Earnings, Employment and Inflation
On Tuesday night I had an interesting conversation with a friend who manages a local grocery store for a large US supermarket chain. He told me that his higher ups have been consistently cutting man-hours to boost productivity and earnings in the face of significant cost pressures. It has now come to the point where the headcount is simply too low. For me, it was an interesting discussion of the microeconomics of macro and I think it has broader implications for what is going on with earnings, employment and inflation.
Here’s what I took away from the conversation:
- Earnings: Companies that have been most affected by food and commodity price inflation have been able to sustain earnings growth only because they have been pushing productivity levels by avoiding adding headcount, or actually squeezing headcount as in my friend’s example. This is unsustainable. My friend told me of an incident which suggested supply chain disruptions could form if more headcount is not added soon. He also said that the share price had been ticking up due to the companies ability to keep down expenses and maintain EPS growth.
- Employment: Many have marvelled at the fantastic growth in earnings by U.S. based companies during the cyclical recovery. This owes to three factors. First, many large companies earn a significant portion of income abroad. With emerging markets still growing, these companies are benefiting from that growth. Second, the global recession which preceded the technical recovery was unusually severe. Clearly, earnings were depressed by a fall in topline numbers, much of which fell to the bottom line because of operating leverage despite headcount reductions. Third, employment growth has been unusually weak. The anecdote my friend relayed is mirrored throughout the corporate world.
- Inflation: The latest ISM data showed that inflation is definitely being felt in the supply chain. At this grocery store, some of the costs have been passed on to consumers. Yet same store sales are down because shopping cart spend is down as people are cutting back, hammered by energy inflation (my friend used some industry standard shopping cart metric that I can’t recall to describe this). The man-hour squeeze is the way the chain is able to keep earnings growth, despite both cost and top line pressures. Now, this is in suburban Virginia outside of Washington, DC which has been insulated from a lot of the unemployment and housing turmoil. So it goes to the demand destruction energy prices are having.
This sort of dynamic is toxic and only works on a temporary basis. By cutting man-hours, individual firms may be able to deal with the pressures squeezing margins from both sides. But, in aggregate over the medium term, this leads to a shortfall in demand unless households accumulate debt. I see one of three outcomes:
- Food and commodity price inflation subside. This would allow the companies to staff up. And since energy prices were declining and other companies would also staff up, demand would increase and EPS could still grow. This is the virtuous circle of higher income growth, leading to more demand for goods and services and higher earnings per share.
- Prices increase as headcount increases despite continued commodity inflation. Since this company is understaffed, the possibility of a breakdown in supply chain management suggests they are going to have to add staff regardless. If costs continue to rise, margins will be under pressure. So this company will be forced to try and pass through those costs if it wants to keep its margins up. his would be the route to higher consumer price inflation.
- Margins erode as cost pressure remains. If the company cannot pass through costs then margins will take a hit and so will earnings.
The bottom line for me is that this store is at a crossroads. It either hires more staff or its going to have problems. This dovetails with my macro view. Recent data suggest we are at the point where energy prices are creating demand destruction. Economic growth has slowed to below 2.% in the US. Further, ISM data suggest that companies are at the breaking point in their ability to absorb costs. The lack of a large move upward in employment suggests that companies have relied on wage and labour cost suppression to maintain EPS targets. Unless, we see a reduction in energy prices, we will either see pressure on EPS growth or increased retail price inflation. My sense is that the demand destruction has set in and that the risk to EPS growth is now to the downside.
P.S. – Luckily, commodity prices are really taking a hit right now. After an initial earnings hit, growth could resume. We will have to see how this plays out.
Here’s what I have said on Twitter just now: