Tuesday, November 9, 2010

ZIRP Thoughts: Labor vs. Capital


In many businesses, there is a trade-off between labor and capital. A very simple example is a ditch-digging business (look under “excavation” in the yellow pages). A ditch-digging entrepreneur can hire a few people, hand them out shovels and send them to the job. Alternatively, the same entrepreneur can purchase an excavator and hire an operator and send him to the job. The trade-off capital vs. labor is pretty clear. The racing track can hire people to check the redeemed tickets or it can have machine-readable tickets with the requisite system. The vending machines in the office can be monitored remotely or a guy can come through and check. The landscaper can push a mower or ride one. You get the idea. Now imagine our ditch-digging entrepreneur could have financed the excavator at 25% last year because the banks thought that ditch-digging is not coming back. This year, however, with the recovery and the bank’s own low-cost financing (0% on demand deposits, 1-2% on 3-year CDs for the typical corner bank), our entrepreneur can finance the said piece of equipment at 6%. Clearly, he’s not buying shovels and not hiring. Capital has won.

Looking at the labor part of the equation, is labor getting more competitive or less competitive vs. capital? My bigger picture view is no, even though high unemployment should be lowering labor cost. Why? The big factor is lack of predictability for labor costs: no one really knows what the effect of the healthcare “reform” will be. The other sad factor is that payroll taxes are the most easily collectible taxes for the Treasury. If there are tax increases, one can expect to see them (eventually) there. Then you have a heavily pro-union administration. The capital maintenance costs are generally predictable: depreciation, consumables, insurance, etc. Oh, and there have been accelerated depreciation tax hand-outs. No wonder capital is winning.

Who benefits from this? You see companies like Wal-Mart and McDonald’s issuing fixed-rate debt at record low yields and investing. It would be criminal for them not to. Where is the money going? Wal-Mart just announced a major acquisition in Africa. McDonald’s is continuing their expansion in emerging markets. These companies are building the future first world. Who’s paying for this? It might very well be you: zero-interest is the destruction of prudent behavior and a confiscation of wealth.

There are other beneficiaries that engage in little-to-no value added financial transactions: PE firms. Ridiculously low high yield rates are encouraging PE takeovers and aggressive dividend recaps. Buyouts also often involve “synergies” (read: labor redundancies) to make the projected IRRs, now advertised as “good” if they are in the teens. But the credit wave surfers will surely make it up on volume.

Where are the landmines in the process I describe above? One is that the commodity inflation is getting out of control. I won’t recite the YTD figures here but when there are such one-directional imbalances (everything is up by a lot), there will be winners and there will be losers. There will be margin compression if you’re short cotton (and not charging 10,000% mark-up for your logo). There will be margin compression if you’re short coffee (and not selling the 20 cent cup for $3.49).

Then there are the legacy pension liabilities for a number of companies (not discussing state/local but they should matter to you if you hold munis). Low bond rates make it very hard for pension plans to meet their projected obligations: this means that companies will eventually have to make large contributions to the plans, essentially transferring money from shareholders/bondholders to former employees.

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