Goldman Sachs sees a new threat to the bull market

Published Wed, May 10 20172:44 PM EDT

Evelyn Cheng @in/evelyn-cheng-53b23624 @chengevelyn

Key Points

Goldman Sachs analysts expect rising wages will prevent S&P 500 companies' ability to grow profits.
Tax reform and increased productivity would offset the negative impact of higher wages. Both look less likely to occur.
Goldman added 11 new stocks to an index tracking companies with low sensitivity to labor costs.

An improving job market is creating the next snag for the stock market, Goldman Sachs analysts said. "We expect rising wages will prevent significant further expansion in S & P 500 margins during the next few years absent corporate tax reform," David Kostin, chief U.S. equity strategist, and strategist Ben Snider said in a Tuesday report. Profit margins for S & P 500 companies hit a record high of 9.2 percent in the third quarter of 2014 and — excluding energy firms — have stagnated since, the report said. Meanwhile, U.S. labor costs as a percentage of S & P 500 companies' revenue have steadily increased to above 10 percent, according to Goldman. The analysts estimated that every percentage point increase in labor cost inflation weighs on S & P 500 earnings per share by 0.8 percent. Industrials and consumer discretionary are "most at risk from rising wages" given historically stretched labor costs and margins, the report said. S & P 500 US labor costs as a % of revenue Source: Goldman Sachs Global Investment Research Wages are on the rise. In the first quarter, the employment cost index rose by 0.8 percent on a seasonally adjusted basis, the most since the fourth quarter of 2007, according to the U.S. Bureau of Labor Statistics. "It's a passing of the baton from corporations to consumers," said Diane Swonk of Diane Swonk Economics. "It doesn't mean a crash in the stock market. It means we may have gotten ahead of ourselves." The S & P 500 traded at all-time highs Wednesday. U.S. stocks have climbed to fresh records since the election as traders bet on increased economic growth from President Donald Trump 's promises such as cuts to the tax rate on returning overseas profits. However, Trump's firing of FBI Director James Comey on Tuesday "takes the oxygen out of the pushing forward the agenda," Swonk said. Small-cap firms have the most at stake on whether Trump's tax proposal is passed. Since they are typically domestically focused, they would likely benefit most from U.S. tax cuts. The firms will need that break if wages continue to rise. Goldman estimates that the margin on earnings before interest and taxes for Russell 2000 firms is about half that of S & P 500 companies. The market may already be signalling its expectations on taxes and wages. The Russell is up 3 percent for the year, less than half the S & P's 7 percent gain. Corporate profits have risen as a % of GDP, while personal income has fallen Source: BEA, Goldman Sachs Global Investment Research "If the reforms don't go through," Swonk said, companies will give investors "stock buybacks and dividends and that's going to disappoint them." Productivity growth can preserve profit margins in a period of rising wages, she said. But since productivity has been on the decline, an increase in wages "changes which are the winners and losers in the market," she said. Last spring, Goldman recommended companies with low sensitivity to labor costs versus those with high exposure. Its basket of stocks with low labor cost sensitivity has gained 8 percent year-to-date, versus 4 percent for the high labor cost index. In the Tuesday note, Goldman added 11 new stocks to its low labor cost basket: Reynolds American, Intercontinental Exchange, Citigroup , Boeing , Broadcom, MasterCard , Western Union, Facebook , HP, Alphabet and Verizon . The analysts also added 15 new stocks to its high labor cost basket including: Marriott, Chipotle Mexican Grill, PepsiCo, Alaska Air, Citrix Systems and CenturyLink. Impact of labor inflation has varied by sector Source: BLS, Goldman Sachs Global Investment Research Disclaimer

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An improving job market is creating the next snag for the stock market, Goldman Sachs analysts said.

"We expect rising wages will prevent significant further expansion in S&P 500 margins during the next few years absent corporate tax reform," David Kostin, chief U.S. equity strategist, and strategist Ben Snider said in a Tuesday report.

Profit margins for S&P 500 companies hit a record high of 9.2 percent in the third quarter of 2014 and — excluding energy firms — have stagnated since, the report said. Meanwhile, U.S. labor costs as a percentage of S&P 500 companies' revenue have steadily increased to above 10 percent, according to Goldman.

The analysts estimated that every percentage point increase in labor cost inflation weighs on S&P 500 earnings per share by 0.8 percent. Industrials and consumer discretionary are "most at risk from rising wages" given historically stretched labor costs and margins, the report said.