Key points

  • Workers should enjoy strong wage growth in the coming years
  • The Chancellor’s drive to cut the welfare bill and encourage inflation that will eat into real debt levels will contribute to this trend
  • However, the expected rise in the new National Living Wage over the next four years spells trouble for some employers
  • Profits are most at risk among pub, catering and restaurant companies, supermarkets, nursing homes, retailers, betting shops and some businesses in support services
  • We believe many companies are also underestimating the overall impact on their wage bills as higher paid employees demand pay rises to maintain differentials

Wage hikes are threatening to call time on profit growth for pubs, supermarkets and care homes, says Simon Young.

The fortunes of UK consumers have undoubtedly improved this year. Household discretionary incomes, as measured by the Asda Income Tracker, increased by over ten per cent year-on-year in September to £192 per week. This is the highest level since the global financial crisis erupted. Moreover, October saw the latest increase to the National Minimum Wage (NMW), while the April 2016 launch of the National Living Wage (NLW), which replaces the NMW for workers aged 25 and over, will further boost incomes. Surely this signifies the start of an enduring boom for UK consumers after a torrid six years?

The Chancellor’s cunning plan

Chancellor George Osborne has committed to raise the NLW to 60 per cent of median earnings by 2020. Under current rates of pay growth, the NLW will reach £9.35 per hour - a 40 per cent increase - over the next four years. There are many reasons why the Chancellor would wish to increase the NLW so aggressively but there are three that we would highlight. Raising the NLW will ensure household incomes maintain their upward trajectory at a time when the government is cutting welfare benefits. By introducing the NLW and cutting welfare benefits, the Chancellor is seeking to reduce government expenditure while pushing the cost of higher wages onto corporates. Finally, after a period of benign inflation, an increase in wages will feed through into the wider economy, nudging up inflation and starting the process of eroding the real value of the government’s huge £1.5 trillion debt pile.

The government estimates that only five per cent of the work force is directly affected by minimum wages, so the initial conclusion is that the issue will be manageable. However, the impact is not evenly spread geographically with Northern Ireland, the North East and Wales having a greater proportion of minimum wage workers. Meanwhile, less than three per cent of the workforce in London is paid the minimum wage.

Boom time for workers spells trouble for employers

Most employees will welcome these developments. In the past year, inflation has been well below the Bank of England’s two per cent target, supressed by falling petrol prices, lower food prices and the lower cost of imported goods due to the rise of sterling. Inflationary pressures also appear benign for the next couple of years. So, an annual rise of approximately ten per cent per annum in the NLW is likely to be substantially ahead of inflation and result in a further real increase in disposable incomes. The flip side of the equation is that many companies, forced to hike pay by the NLW legislation, face a wage bill that will rise at a pace that is well above that of inflation. Some companies can doubtless offset some of the inflationary pressure through innovation. Others will resort to the age-old solution of reducing hours through forced or voluntary measures. Finally, a handful will increase prices to offset the rising wage bill, reminding us of Warren Buffett’s observation:

“If you’ve got the power to raise prices without losing business to a competitor, you’ve got a very good business. And if you have to have a prayer session before raising the price by ten per cent, then you’ve got a terrible business.”

It is those prayer session attendees that really worry us. The impact of the NLW will be felt most negatively in those industries where: low-skilled employees account for a large proportion of the workforce; wages are a relatively high percentage of the cost base; the ability to raise prices is low and profit margins are thin. Over the coming four years, we believe profits are most at risk among pub, catering and restaurant companies, supermarkets, nursing homes, retailers, betting shops and some businesses in the support services sector.

The ratchet effect

The stock market currently appears quite relaxed about the NLW issue given the minority of the workforce directly affected. However, we fear that the impact on profits could be worse than anticipated. Why? The rise in wages will not simply be confined to those earning the NLW. Wages tend to be tiered, rising with seniority but typically benchmarked to earnings in the lower tier. If those workers earning the lowest wages receive a pay rise, those earning higher wages will also demand pay hikes to maintain differentials. The Low Pay Commission has estimated that around 2.5 million people, or ten per cent of the workforce, is currently on the minimum wage or classed as lowly paid. We think that at least ten per cent of the workforce will see above inflation wage increases for the next four years.

Company management teams, when asked about the impact of the NLW, have tended to respond by quantifying the effect solely from workers who will earn the NLW. We have seen fewer responses that take account of the likely upward shift in all pay levels of up to, say, £12 per hour. National pub company JD Wetherspoon was one of the first to warn that profits in 2016 would fall below this year’s. This is a direct consequence of Wetherspoon’s inability to offset NLW wage increases made prior to its official implementation. Interestingly, Young & Co Brewery, a London-centric pub operator, where minimum wages are a much smaller proportion of the wage bill and consumers are more affluent, sees no such problem.

Supermarkets are already fighting the dual threats of internet-based models, like Ocado or Amazon Fresh, and the giant-killing discounters such as Aldi and Lidl. A growing cost base is the last thing that they need. We estimate Morrisons, Tesco and Sainsbury have a combined UK wage base of over £8 billion. A fair proportion of their employees is paid either the NLW, or close to it. Even if wages rise at only four per cent per annum they face a £320 million headwind per annum. Given the deleterious effects of the internet challengers and discounters on their profit pools, could this be the straw that breaks the camel’s back?

Merry Christmas one and all

We think the NLW issue will be given greater prominence towards the end of the year as outlook statements for 2016 admit that the impact of the NLW will be worse than first thought. So as Christmas approaches, we believe there will be a distinct lack of festive cheer among the industries that we have highlighted.

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Unless stated otherwise, any sources of all information is Aviva Investors Global Services “Aviva Investors”) Limited as at 20 November 2015. Unless stated otherwise any views and opinions expressed are those of the author and should not be viewed as indicating any guarantee of return from an investment managed by Aviva Investors nor as advice of any nature. The value of an investment and any income from it may go down as well as up and the investor may not get back the original amount invested. Aviva Investors Global Services Limited, registered in England No. 1151805. Registered Office: St. Helen’s, 1 Undershaft, London EC3P 3DQ. Authorised and regulated in the UK by the Financial Conduct Authority and a member of the Investment Association.

RA15/0810/29022016