As I was waiting in line at Starbucks yesterday, the Wall Street Journal’s front page headline caught my attention.
Interesting, I thought. Maybe the bond market is finally noticing what I’ve been documenting over the past two quarters — corporate costs (especially labor) are on the rise. And then this morning I woke up to another inflationary data point, “Walmart to raise starting hourly wage to $11, expand parental leave benefits, and issue bonuses of $1,000”. Most pundits are contributing the increase in compensation to the new tax law. This may be true, but based on my bottom-up observations, the move may also be a result of market trends in labor.
Last quarter I wrote the following as it related to Q3 earnings, “Wage pressures were mentioned frequently, while raw material costs were also noticeably higher for many industrial companies. To be clear, I don’t believe inflation is spiking higher, but the trend has definitely shifted. Specifically, the trend in inflation appears to have moved from fears of deflation (2015-2016), to slow to moderate inflation.”
As earnings season begins, I will continue to monitor trends in costs and labor closely. However, based on recent operating results, I suspect these trends will remain intact and will become more noticeable in certain industries with growing capacity constraints. Construction is a good example.
KB Home (KBH) and Lennar (LEN) both reported earnings yesterday and had similar commentary related to costs and labor. Both companies are raising prices as a result of higher prices and strong demand. KBH Home notes, “In the fourth quarter, our overall average selling price of homes delivered increased 8% to $416,500.” Lennar mentioned a similar increase in price stating, “Revenues from home sales increased 14% in the fourth quarter driven by a 5% increase in wholly owned deliveries and an 8% increase in average selling price to $387,000.”
KB Home also discussed costs stating, “…higher margins in recently opened communities, will offset expected increases in trade labor, building materials and land cost.” Lennar’s comments on labor were a little more descriptive, mentioning there was a “labor shortage”. Specifically Lennar stated, “The low unemployment rate and the labor shortage has been translating into wage growth…”
Material prices were up as well. An analyst on Lennar’s call commented, “Costs up 8% in addition to labor being up 6%, surprised me a little bit.” Management explained, “The bulk of that cost increase is really lumber increases that had taken place earlier in the year but were flowing through our cost of sales. So lumber, both labor and materials associated with framing, were up — were — made up 32% of that 8% increase year-over-year.”
Similar to most companies involved in construction, KBH Home and Lennar each reported strong operating results. Based on these and other recent earnings reports, my outlook for Q4 earnings and growth remains unchanged. Specifically, last quarter I wrote, “Looking forward, outlooks and commentary suggest the economic and profit cycle will continue into Q4 2017. Barring a sharp decline in asset prices (financial markets and economy appear to be one and the same currently), I’m expecting approximately 3% growth in Q4. Overall, I believe Q4 will be similar to slightly better than Q3, with easier comps in consumer and slightly tougher comps in certain industrials and energy. Business outlooks appear more confident this quarter versus Q3.”
As earnings season begins, I’m looking forward to learning more soon. That said, I’m expecting operating trends I noticed last quarter to continue. If so, it could be another quarter that threatens the widely-held belief interest rates will remain lower for longer. While investors focus on another “melt-up” in equity prices, I’m more interested in the bond market and the growing awareness that something has changed. While I believe this change started a few quarters ago, better late than never!