Wall Street just can't get enough red flags these days.

Almost everywhere investors turn, signs of inflationary pressures make it less likely the Federal Reserve will pause from two years of interest rate increases.

Stock investors have tied themselves in knots worrying about rising energy and commodity prices, fearing these will force the Fed to stay on the inflation warpath.

Meanwhile, labor costs -- the biggest cost of doing business -- have largely been on the back burner, as wage gains by U.S. workers remained relatively tame. Until now.

For the first time since the recession about five years ago, U.S. wages are catching up with inflation as the unemployment rate stays low and the work week lengthens.

At a 4.7 percent unemployment rate, U.S. workers do have the leverage to ask for higher wages or benefits, and that's part of the problem, said Marc Pado, Cantor Fitzgerald's chief U.S. market strategist.

Case in point: The latest monthly productivity report from the Labor Department showed hourly pay rose at a 5.7 percent annualized pace in the opening three months of 2006, more than double the 2.7 percent pace in the previous quarter.

First-quarter unit labor costs -- a key gauge of profit and price pressures monitored by the Fed for clues on wage inflation -- increased at a 2.5 percent annual pace, more than economists had predicted at the time.

Furthermore, employees are working longer each week than they have in nearly four years, a detail often viewed as a sign of labor scarcity and a signal of higher pay rates.


Analysts say mounting wage pressures are poised to squeeze corporate profits and create a new headwind for U.S. equities, which have enjoyed 16 consecutive quarters of double-digit earnings growth.

At greatest risk are small-cap companies, a sector that has defied repeated predictions of its demise, consistently outperforming larger peers for more than five years.

As U.S. compensation costs rise this year, many small- and mid-cap firms will have little choice but to pay up, trimming revenue and profit margins, said Joseph Quinlan, chief market strategist at Banc of America Capital Management.

When the pool of available workers was large and wages stagnated, small caps didn't have a problem competing with big caps for new hires, but the relatively low unemployment now has given workers more bargaining power and put small companies at a disadvantage, he said.

The Russell 2000 index, a measure of small-cap companies, has risen 6.3 percent this year and would appear to be outpacing the big-cap crowd yet again. By contrast, the Dow Jones industrial average <.DJI> is up just 3.7 percent.

Since February 28, however, the Russell is actually down more than 2 percent, whereas the Dow has eked out a 1.2 percent gain despite a thrashing in recent sessions that has cost the index nearly 5 percent.

Shares of large-cap stocks, such as heavy equipment maker Caterpillar Inc. and plane maker Boeing Co., have been surging, boosted by expectations that growth in India and China will sustain demand for their products.


Now some money managers say they have begun limiting their exposure to small-caps, tipping in favor of big caps.

In recent days, the sell-off in U.S. stocks has centered around heavy industrial stocks like Caterpillar, but analysts said the market could yet see big-cap gains.

They said foreign exposure would help keep earnings of big-cap companies strong if the U.S. economy stalls after four years of double-digit growth in earnings.

The large companies would be in a better position to offset rising wage pressures at home by tapping into their operations in the far flung parts of the world.

We are very confident that small-cap stocks are going to begin to underperform large-cap stocks because of the fact that they don't have the ability to out-source their employment internationally, said Christopher Zook, chairman and chief investment officer at CAZ Investments, in Houston, Texas.

About half of the companies in the Dow Jones industrial average have more than 50 percent of their work force based abroad, according to analysts.