Is a dangerous wage bubble now looming large .......

The most common jargon in any financial opinion/article today relates to one or the other bubble. Economists like Roubini, also known as Dr. Doom (To his credit - he predicted the 2009 Financial crisis to the T) will use the bubble jargon at the drop of the hat quite literally. To make matters worse there are as many types of bubble narratives floating around– the Real estate bubble, the stock market bubble, the Private equity bubble, the technology bubble, the cryptocurrency bubble, and then the big bubbles and small bubbles… blah blah blah. Alas, I only knew about the soap bubbles in my day and age which were blown through a fancy “tech” toy clandestinely as the teacher looked away in class.

So the rudimentary question – what are these financial bubbles? Basis my understanding, bubbles signify asset prices that have blown through the roof due to inflationary conditions. Typically bubbles are formed when “cheap money” is available to the market participants leading to price increases unwarranted by fundamentals and logic. The most relatable example would be a very low-interest rates scenario (cheap money) leading to everyone picking up loans to buy real estate. With more money chasing the same goods (Demand-pull inflation), the fundamental market indicators like cap rates/past transaction values go out of the window and prices breach one level after the other. This cycle continues to exist till the next buyer has money to overhaul the previous price levels. Sadly enough the cycle doesn’t last forever and the next best buyer dissipates leading to the “bursting of the bubble”. Those who were riding the bubble at the burst (loan takers/investors) or those who never exited (loan providers/leverage givers) face undue pain and losses?

?The next fundamental question is – can only assets experience bubbles? Well, I think so not. Let’s just pick up the case of wages/salaries. Wages/salaries are classified as “expenses” and not assets (eventually all assets are expenses – just that long-term benefit yielding expenses are classified as assets but for simplicity, let's segregate them now). Can wages experience bubbles? Unless am being misled (by confirmation bias or sample bias) – I am pretty sure we’ve now entered a period of wage bubble. A wage bubble (just like an assets bubble) may be a phenomenon wherein the wages of employees rise exponentially all of a sudden and this increase may seem bereft of logic and fundamentals

?What causes wage bubbles :?

For simplicity's sake again, am going to pick an example that I understand well – the financial services outsourcing industry. The two most profound yet positive impact (s) of Covid for our incumbents have been a) the EBITDA margins zooming owing to shrinking overheads b) outsourcing as a service seeing the second awakening of sorts as clients cease to differentiate between employees sitting at home in NY City/Chicago or Gurgaon (as extended teams/outsourcing partners). Both these tailwinds have been revenue and margin accretive at the same time. Talking to a couple of stalwarts from the industry has also been confirmed my hunch. Some of the behemoths of the outsourcing industry have experienced EBITDA margins to double from 15% (pre-covid) to ~ 28-30% during the last financial year. All the incumbents are also steadily expanding teams (almost at a frenzied pace) as FTE’s/contracts increase.

?Let's just dissect the EBITDA expansion at this stage. Doubling of EBITDA margin has meant large cash conversions on every dollar received. High cash conversion may then translate into higher cash flows with incumbents now sitting on a large enough cash pile with future expansion looking imminent. So what do these cash-rich companies do? Investing in the existing workforce (training and salary increases) can have constraints and boundaries. So what's next? Most companies are lured (into a trap) of hiring indiscriminately at this stage. A scenario where Company A offers Employee Z working at Company T at 100% with some obscenely exorbitant add-on’s is not unheard of. To stem attrition Company T would then counteroffer to match Company A’s offer. This cycle continues till someone gives up. With more cash sitting on the balance sheet – companies also almost indulge in their campus recruitment programs (the competition to beat each other at salaries offered becomes campus folklore) – taking the starting salaries offered at campuses up by many notches. A long story cut short – salaries/wages for all new employees (lateral or campus hires) increase as more money chases the same resources without any significant increases in skill-sets.

?Medium to Long-term Pain???

Like all myths and bubbles – the wage bubbles are likely to go bust at some point in time. However, the more immediate impact for companies would be existing employees demanding higher salary increases or would be willing to flip as opportunities swing by. Once companies start to realize that the difference between the haves and have not’s is significant and causing disenchantment – they would be forced to revise/correct salaries of existing employees to a level that may seem reasonable. This would again strain the P&L in the medium-term and in the long-term (salaries don’t get revised downwards normally). In the long run, the overheads are likely to come back strongly and thus the doubled-up EBITDA margin would likely wane quickly too. Rather astronomical salaries and splurges are likely to nose-dive EBITDA margins even below the pre-Covid era. Growth stories do falter further down the road, and the law of averages takes over (unless we see networking effects). Just like in the asset markets where those who rode the bubble last (employees hired at unsustainable salaries) and investors (our incumbents) are likely to face large losses and pain. The moral of the story …just like the house prices which go up temporarily without any additional features and benefits, the wage bills also go up several notches without a dramatic change in the “skill-sets” or experience and when corrections happen – somebody is bound to pay.?

?Are there any better alternatives for investment/reinvestments??

In my opinion, here are some better uses of cash?

1.Buy technology rather than people?– The start-up landscape is flush with new world automation tools and “gizmos”. Rather than increasing the workforce in tandem with the increase in expected revenues – incumbents should think more like Elon Musk rather than corporate demi-gods of the past. In the next 10 years – most of the repetitive processes would be automated. If this is true – many of the tasks done at back-offices would be fully automated. What are we waiting for then? Company acquisitions can be trickier and pricier but will hordes of cash – maybe there can be a bigger bang for the buck. Additionally, moving from a service company to a product company has its own merits. Think of an outsourcing partner which has a product that they can sell directly to their client’s client. Isn't that called moving vertically in the value chain and capturing the economic surplus which everyone in the chain is eventually vying for?

?2. Mathematical illusion??– One of the very important and ground-breaking works of late Prof Christensen related to how disruptive forces interact creating value for companies. His idea revolved around asking companies to invest in employee ideas, and this creative idea received considerable acclaim. However, at the ground level – seldom ideas coming from below are accepted. Either the middle managers blow and rubbish these ideas or the processes for idea selection are so cumbersome that they are lost in the wilderness. Additionally, each idea is looked through the lens of mathematically inaccurate ROI for which a ground-level employee may not have great justification. On the flip-side, organizations rarely calculate ROI on their expensive hires and access whether high salaries have any justification. Maybe higher budgets and a PE-type philosophy (only 1 idea out of the 10 can be a game-changer when investing in all of them). However, this culture change is evolutionary and requires patience

?3.Loyalty Bonuses?– Loyal employees do not jump ship. They always seem to have an “eternal connection” with the firm and wouldn’t leave even when pushed to the edge. I am not talking about people who hang around just because they don’t have any options or have mastered the dark arts of survival. These loyal employees fully believe in the company’s vision and mission are part of the “culture” and the mix then becomes endearing to prospective employees. More often than not loyal employees aren’t treated the way should be. They may not be your best political animals hanging around power-hungry corridors pleasing top management or bosses but ones who quietly do their job and are also vociferous about things/policies/strategies not looking ok. Many times - these employees are looked down upon as they can't be “yes men” or question management policies. A good management system shouldn’t find it too hard to identify such gems and then be brave enough to reward them for what they deserve.??????

Disclaimer:‘The views expressed in the article are of the author and do not necessarily represent the firm’s views.’?