A lot of commentary assumes Labor costs is the only variable in the “inflation” equation. We “must” have unemployment to control labor costs!!!! This is an article of faith for your typical Wall Street Journal reader.
But price is set by 3 variables, not just labor costs.
Price = materials costs** + labor costs + profit margin
Wages are very sticky. Since you can’t usually cut wages, you MUST cut workers. Correct – assuming you are solving for constant profits.
However, the most “variable” variable above is actually profits. Corporate profits have been sky high for 2 years. I wish I had seen the corporate profits chart in this tweet last year. If there was a bubble anywhere, it was here.
Reverting from 13% margins to the pre-COVID 10% margins implies a ~25% drop in profits. That just gets us back to prior trend.
Stable earnings have bolstered the market recently. From here on, however, it will likely be the margin story that defines this cycle. Margins may be hard-pressed to remain as high as they have been since recovery from the pandemic. pic.twitter.com/Lz7772KixK
— Jurrien Timmer (@TimmerFidelity) August 10, 2022
While “everyone” looks for a big increase in unemployment, an equally plausible 2023 scenario is…
- Fairly stable employment with sticky wages (labor costs stay high).
- Materials costs are always hard to predict**, but lets say supply shocks fade and that creates room for price cuts and discounting.
- “The cure for high prices is high prices.” Price destroys demand – free market 101″. At some magical point, we get off a lot of vertical demand curves. Think about airline seats – if you have 2 empty seats left, the marginal price the day before the flight is $1,000. If you have 10 empty seats left, it is $500. if you have 20 empty seats, it is $200. Small shifts in demand drive big swings in price.
End results for companies depends…
- If they are the lucky few with strong pricing power (most companies don’t have much) => No problem we raised prices and can hold them.
- Everyone else = paying higher wages supplying into a softer market with less demand. The hit will flows to profits.
A profits recession will still suck, but it wouldn’t be the employment recession you read about in the WSJ. In reality, I’d probably expect a bit of both. But profits are the more variable variable.
The obvious investment conclusion is “own companies with pricing power.” Preferably those seeing strong demand.
** Materials costs are high now, but very hard to predict. I will note two rules of thumb:
- The cure for high prices is… high prices.
- “I’ve seen gluts not followed by shortages, but I’ve never seen a shortage not followed by a glut.”