Misjudged wage growth divides small-cap market

Despite inflation driving up cost of living expenses faster than wages, Maple-Brown Abbott’s Australian small-cap experts believe the lagging effects are about to catch up and reverse.

Phillip Hudak, Co-Portfolio Manager of Australian Small Companies at Maple-Brown Abbott said wage inflation is trending higher despite it not showing in official statistics, with the effects on the labour market expected to show in the coming six to 12 months.

He said this will cause the Australian small cap market to separate between those than “can cope with rising wages using pricing power, cost cutting an/or productivity initiatives – and those that can’t”.

“This risk of further wage inflation is evident in the sharp increase in wage rates being set for new EBAs with employees expecting annual wage increases to be even greater over the next 12 months as cost-of-living pressures persist.

“This classic wage-price spiral is happening when the unemployment rate remains close to record lows, although we acknowledge a loosening in labour market tightness, as indicated by labour underutilisation (i.e. unemployment and underemployment),which has recently increased but remains well below pre-Covid levels.

“In addition, job vacancies remain elevated although below peak levels and productivity weakness is raising concerns that more significant wage inflation may be underway.

Hudak said sectors such as healthcare, retail and information technology are set to be impacted more due to their high labour cost intensity and low pricing power.

“We prefer companies with a variable cost base and pricing power. Within the healthcare sector IVF providers stand out. Monash IVF Group continues to be a beneficiary of structural industry drivers including an older demographic, egg freezing and genetic testing.

“In addition, the company is currently seeing tailwinds from strong domestic industry IVF cycle volumes and price increases which are at or above underlying cost inflation – all of which we expect to result in operating leverage.

“In addition, we also prefer segments of the healthcare sector receiving additional government funding to support material wage increases, notably the aged care sector via exposure to Regis Healthcare.”

Hudak said retailers targeting younger consumers have experienced low top-line sales growth in alignment when wage inflation expectations of at least mid-single digit percentage growth.

“As sales growth softens, such firms are having to decrease service levels, including reducing staffing levels during non-peak trading periods, and further implement productivity improvements. Even with such tightening measures, we believe this won’t be enough to offset CODB/Sales pressures,” he said.

“We believe the delayed flow-through of wage inflation in Australia will have a material down-stream impact on the profitability of select sectors of the Australian small cap market over the next 6-12 months – which the market is under-appreciating.

“Specifically, we expect a material impact on sectors/companies with high labour components as a percentage of sales that have minimal pricing power and are riding abnormal post-Covid sales waves. As the market increasingly appreciates the impact of rising wages we expect to see an increasing bifurcation in the performance of ‘good’ and ‘poor’ businesses going forward.

“We believe the wage-price nexus creates a great environment for active management in the Australian small caps market and we continue to focus on investing in companies with genuine pricing power to offset lagged labour cost pressures.”