Latest figures show that wages rose by 2.7 per cent in the year to the three months ending in April, the biggest increase since 2011. These rises are not being matched by productivity gains: output per hour probably rose only 0.7 per cent in this period. With inflation low, this implies a squeeze on profit margins.
In itself, such a squeeze needn't be much of a problem if lower margins are offset by higher volumes. But this might not happen.
To see what I mean, let's use a framework for thinking about profits which I've always considered useful. We start from two national accounts identities. The first says that GDP is the sum of consumer spending (C), investment (I), government spending (G) and net exports (NX):
Y = C + I + G + NX
The second says that GDP is also equal to the sum of wages (W), profits (P), taxes (T) and other incomes such as those of the self-employed (O):
Y = W + P + T + O
Rearranging these gives us an identity for profits:
P = (C – W) + I + (G – T) + NX – O
This tells us something important - that a rise in wages in itself is not a threat to profits as long as the higher wages are matched one-for-one by a rise in consumer spending.
However, I doubt this will happen. Several things suggest that wages might rise faster than consumer spending, which would mean that profits are squeezed.
One, of course, is simply that higher wages will leak away from British firms because some will be grabbed by the tax man in the form of higher taxes or lower tax credits and another part will flow overseas in the form of spending on imports.
Also, wage-earners might use their extra income to add to their savings or to reduce their debt. This is especially likely if they believe their higher wages won't last long: the permanent income hypothesis tells us that the propensity to spend out of a temporary rise in income is low.
There's a third problem: even to the extent that workers do spend their higher wages upon British goods and services, it might not wholly benefit profits. This is because those other incomes have been playing an important role. In recent years we've seen a shift towards self-employment and away from corporate sector activity. If we spend our higher wages at farmers' markets rather than in supermarkets, in small independent coffee shops rather than in chains, on gardeners and handymen rather than DIY goods and so on, then the profits of the corporate sector will be squeezed.
For these reasons, I suspect a rise in wages would be bad for profits. The best hope for investors is not so much that wages will be recycled towards companies but rather that the rise in wage growth won't carry on for much longer.
You might object that all this doesn't much matter for equity investors because most profits come from overseas. This is true for the FTSE 100, but much less so for smaller stocks. For this reason, if the pick-up in wage growth does continue, the trend of the last five years for small caps to out-perform bigger stocks might come to an end, and perhaps might even be reversed.
