Wage increases haven’t made a dent in profits

Average hourly earnings growth continues to rise, albeit at a leisurely pace. Average hourly earnings for all employees in the private sector grew at 2.92% over the last 12 months, while production and nonsupervisory employee earnings grew at 2.80% over the same period. The Fed is likely to adopt a more restrictive stance if hourly earnings growth, representing underlying inflationary pressures, exceeds 3.0%. So far the message from Fed Chair Jerome Powell has been business as usual, with rate hikes at a measured pace.

Average Hourly Earnings

Rising wage rates to-date have been unable, up to Q2 2018, to make a dent in corporate profits. Corporate profits are near record highs at 13.4%, while employee compensation is historically low at 69.5% of net value added. Past recessions have been heralded by rising employee compensation and falling corporate profits. What we are witnessing this time is unusual, with compensation rising, admittedly from record low levels, while profits rebounded after a low in Q4 2016. There is no indication that this will end anytime soon.

Corporate Profits and Employee Compensation as Percentage of Value Added

Weaker values (1.17%) on the Leading Index from the Philadelphia Fed reflect a flatter yield curve. A fall below 1.0% would be cause for concern.

Philadelphia Fed Leading Index

Our surrogate for real GDP, Total Payrolls x Average Weekly Hours Worked, is lagging behind recent GDP growth (1.9% compared to 2.9%) but both are rising.

Real GDP and Total Payroll*Average Hours Worked

Another good sign is that personal consumption expenditure, one of the key drivers of economic growth, is on the mend. Services turned up in Q2 2018 after a three-year decline. Durable goods remain strong. Nondurables are weaker but this may reflect a reclassification issue. New products such as Apple Music and Netflix are classified as sevices but replace sales of goods such as CDs and videos.

Personal Consumption

There is no cause for concern yet, but we will need to keep a weather-eye on the yield curve.

Markets are constantly in a state of uncertainty and flux, and money is made by discounting the obvious and betting on the unexpected.

~ George Soros

US adds 222 thousand jobs

From the Wall Street Journal:

U.S. employers picked up their pace of hiring in June. Nonfarm payrolls rose by a seasonally adjusted 222,000 from the prior month, the Labor Department said. The unemployment rate ticked up to 4.4% from 4.3% the prior month as more people joined the workforce…..

Job Gains

Source: St Louis Fed & BLS

Forecast GDP for the current quarter — total payrolls * hours worked — is rising, showing an improving economy.

Real GDP Forecast

Source: St Louis Fed, BLS & BEA

Declining corporate profits as a percentage of net value added (RHS) is typical of mid-cycle growth, while employee compensation (% of net value added) is rising at a modest pace. Peaks in employee compensation are normally accompanied by troughs in corporate profits…..and followed by a recession.

US Corporate Profits and Employee Compensation as percentage of Value Added

Source: St Louis Fed & BEA

Average wage rate growth, both for production/non-supervisory and all employees, remains below 2.5% per year. Absence of wage rate pressure suggests that the Fed will be in no hurry to hike interest rates to curb inflationary pressure.

Hourly Wage Rate Growth

Source: St Louis Fed & BLS

Which should mean further growth ahead.

A bump for Donald Trump next year

From Tim Wallace at The Age:

Nine years on from the start of the financial crisis, the US recovery may be overheating, Legal & General Investment Management economist James Carrick has warned.

He has predicted a series of interest rate hikes will tip the US into a 2018 recession.”Every recession in the US has been caused by a tightening of credit conditions,” he said, noting inflation is on the rise and the US Federal Reserve is discussing plans for higher interest rates.

Officials at the Fed have only raised interest rates cautiously, because inflation has not taken off, so they do not believe the Fed needs to take the heat out of the economy.

But economists fear the strong dollar and low global commodity prices have restricted inflation and disguised domestic price rises. Underneath this, they fear the economy is already overheating.

As a result, they expect inflation to pick up sharply this year, forcing more rapid interest rate hikes.

That could cause a recession next year, they say. In their models, the signals are that this could take place in mid-2018.

I agree that most recessions are caused by tighter monetary policy from the Fed but the mid-2018 timing will depend on hourly earnings rates.

Hourly earnings are a good indicator of underlying inflationary pressure and a sharp rise is likely to attract a response from the Fed. The chart below shows how the Fed slams on the brakes whenever average hourly earning rates grow above 3.0 percent. Each surge in hourly earnings is matched by a dip in the currency growth rate as the Fed tightens the supply of money to slow the economy and reduce inflationary pressure.

Hourly Earnings Growth compared to Currency in Circulation

Two anomalies on the above chart warrant explanation. First, is the sharp upward spike in currency growth in 1999/2000 when the Fed reacted to the LTCM crisis with monetary stimulus despite high inflationary pressures. Second, is the sharp dip in 2010 when the Fed took its foot off the gas pedal too soon after the financial crisis of 2008/2009, mistaking it for a regular recession.

Hourly earnings growth has risen to 2.5 percent but the Fed is only likely to react with tighter monetary policy when earnings growth reaches 3.0 percent. Recent rate rises are more about normalizing interest rates and are no cause for alarm.

I am more concerned about the impact that rising employment costs will have on corporate earnings.

The chart below is one of my favorites and shows the relationship between employee compensation and corporate profits (after tax) as a percentage of net value added. Profit margins rise when employment costs fall, and fall when employment costs rise.

Profits After Tax v. Employment Costs as a Percentage of Value Added

Employee compensation is clearly rising and corporate profits falling as a percentage of net value added. If this trend continues in 2017 (last available data is Q3 2016) then corporate earnings are likely to come under pressure and stock prices fall.

Source: Warning of bump for Donald Trump next year with slide into recession

Are US stocks really over-valued?

Let us start with Warren Buffet’s favorite market valuation ratio: stock market capitalization to GDP. I have modified this slightly, replacing GDP with GNP, because the former excludes offshore earnings — a significant factor for multinationals.

US stock market capitalization to GNP

The ratio of stock market capitalization to GNP now exceeds the highs of 2005/2006, suggesting that stocks are over-valued — approaching the heady days of the Dotcom era.

Corporate Profits

If we dig a bit deeper, however, while the ratio of market cap to sales is also high, market cap to corporate profits remains low.

US stock market capitalization to Business Sales and Corporate Profits

Clearly profit margins have widened, with corporate profits increasing at a faster rate than sales. The critical question: is this sustainable?

Sustainability of Profits

At some point profit margins must narrow in response to rising costs. Increases in aggregate demand may lift employment and sales, but also drive up labor costs.

Profits and Labor Costs as a percentage of Net Value Added

The brown line above depicts labor costs as a percentage of net value added, compared to corporate profits (blue) as a percentage of net value added. There is a clear inverse relationship: when labor costs rise, profit margins fall (and vice versa). At first the effect of narrower margins is masked by rising sales, but eventually aggregate profits contract when sales growth slows (gray stripes indicate past recessions).

Interest Rates and Taxes

Other contributing factors to high corporate profits are interest rates and taxes. Corporate profits (% of GNP) have soared over the last 30 years as bond yields have fallen. The benefit is two-fold, with lower interest rates reducing the cost of corporate debt and lower finance costs boosting sales of consumer durables.

Corporate Profits as % of GNP and AAA Bond Yields

Lower effective corporate tax rates (gray) have also contributed to the surge in profits as a percentage of GNP.

US stock market capitalization to GNP

The most enduring of these three factors (labor costs, interest rates, and tax rates) is likely to be taxes. Corporate tax rates have fallen in most jurisdictions and US rates are high by comparison. Even if a long-overdue overhaul of corporate taxation is achieved in the next decade (don’t hold your breath), the overall tax rate is likely to remain low.

If Not Now, When?

The other two factors (labor costs and interest rates) may not be sustainable in the long-term but it will take time for them to normalize.

Treasury yields are rising, with the 10-year at 2.37 percent. Breakout above 3.0 percent still appears some way off, but would confirm the end of the 35-year secular down-trend.

10-Year Treasury Yields Secular Trend

Interest rates are likely to remain low until rising labor costs force the Fed to adopt a restrictive stance.

Labor Costs as a percentage of Net Value Added

Labor markets have tightened to some extent, as indicated by the higher trough on the right of the above graph. But this is likely to be slowed by the low participation rate, with potential employees returning to the workforce, and a strong dollar enhancing the attraction of cheap labor in emerging markets.

Hourly earnings growth in the manufacturing sector remains comfortably below the Fed’s 2.0 percent inflation target. Any breakout above this level, however, would be cause for concern. Not only would the Fed be likely to raise interest rates, but profit margins are likely to shrink.

Manufacturing: Hourly Earnings Growth

For the present

None of the macroeconomic and volatility filters that we monitor indicate elevated market risk. I expect them to rise over the next two to three years as the labor market tightens and interest rates increase, but for the present we maintain full exposure to equities.

Are US stocks really over-valued?

Stock Market Capitalization

Let us start with Warren Buffet’s favorite market valuation ratio: stock market capitalization to GDP. I have modified this slightly, replacing GDP with GNP, because the former excludes offshore earnings — a significant factor for multinationals.

US stock market capitalization to GNP

The ratio of stock market capitalization to GNP now exceeds the highs of 2005/2006, suggesting that stocks are over-valued — approaching the heady days of the Dotcom era.

Corporate Profits

If we dig a bit deeper, however, while the ratio of market cap to sales is also high, market cap to corporate profits remains low.

US stock market capitalization to Business Sales and Corporate Profits

Clearly profit margins have widened, with corporate profits increasing at a faster rate than sales. The critical question: is this sustainable?

Sustainability of Profits

At some point profit margins must narrow in response to rising costs. Increases in aggregate demand may lift employment and sales, but also drive up labor costs.

Profits and Labor Costs as a percentage of Net Value Added

The brown line above depicts labor costs as a percentage of net value added, compared to corporate profits (blue) as a percentage of net value added. There is a clear inverse relationship: when labor costs rise, profit margins fall (and vice versa). At first the effect of narrower margins is masked by rising sales, but eventually aggregate profits contract when sales growth slows (gray stripes indicate past recessions).

Interest Rates and Taxes

Other contributing factors to high corporate profits are interest rates and taxes. Corporate profits (% of GNP) have soared over the last 30 years as bond yields have fallen. The benefit is two-fold, with lower interest rates reducing the cost of corporate debt and lower finance costs boosting sales of consumer durables.

Corporate Profits as % of GNP and AAA Bond Yields

Lower effective corporate tax rates (gray) have also contributed to the surge in profits as a percentage of GNP.

US stock market capitalization to GNP

The most enduring of these three factors (labor costs, interest rates, and tax rates) is likely to be taxes. Corporate tax rates have fallen in most jurisdictions and US rates are high by comparison. Even if a long-overdue overhaul of corporate taxation is achieved in the next decade (don’t hold your breath), the overall tax rate is likely to remain low.

If Not Now, When?

The other two factors (labor costs and interest rates) may not be sustainable in the long-term but it will take time for them to normalize.

Treasury yields are rising, with the 10-year at 2.37 percent. Breakout above 3.0 percent still appears some way off, but would confirm the end of the 35-year secular down-trend.

10-Year Treasury Yields Secular Trend

Interest rates are likely to remain low until rising labor costs force the Fed to adopt a restrictive stance.

Labor Costs as a percentage of Net Value Added

Labor markets have tightened to some extent, as indicated by the higher trough on the right of the above graph. But this is likely to be slowed by the low participation rate, with potential employees returning to the workforce, and a strong dollar enhancing the attraction of cheap labor in emerging markets.

Hourly earnings growth in the manufacturing sector remains comfortably below the Fed’s 2.0 percent inflation target. Any breakout above this level, however, would be cause for concern. Not only would the Fed be likely to raise interest rates, but profit margins are likely to shrink.

Manufacturing: Hourly Earnings Growth

For the present

None of the macroeconomic and volatility filters that we monitor indicate elevated market risk. I expect them to rise over the next two to three years as the labor market tightens and interest rates increase, but for the present we maintain full exposure to equities.

Are corporate profit margins sustainable?

Market capitalization as a percentage of (US) GNP is climbing and some commentators have been predicting a reversion to the mean — a substantial fall in market cap.

US Market Cap to GNP

But corporate profits have been climbing at a similar rate.

US Corporate Profits to GNP

Wages surged as a percentage of value added in the first quarter (2014) and profit margins fell sharply, adding fresh impetus to the bear outlook. But margins recovered to 10.6% in the second quarter.

Employee Compensation and Profits as Percentage of Gross Value Added

Further gains in the third quarter would suggest that profits are sustainable. Research by Morgan Stanley supports this view, revealing that improved profit margins are largely attributable to the top 50 mega-corporations in the US:

Mega cap companies (the largest 50 by size) have been able to pull their margins away from the smaller companies through globalization, productivity, scale, cost of capital, and taxes, among other reasons. We argue against frameworks that call for near-term mean reversion and base equity return algorithms off the concept of overearning. Why? The margins for the mega cap cohort in the last two downturns of 2001 and 2008 were well above the HIGHEST margins achieved during the 1974-1994 period. To us, this is a powerful indication that the mega cap cohort is unlikely to mean revert back to the 1970s to 1990s average level.

(From Sam Ro at Business Insider)

Also interesting is The Bank of England’s surprise at the lack of inflation in response to falling unemployment. One would expect wage rates to rise when slack is taken up in the labor market, but this has failed to materialize. It may be that unemployment is understated — and a rising participation rate will keep the lid on wages. If this happens in the US it would add further support for sustainable profit margins.

Is the market overpriced? Episode V

In my last post I concluded that the same factors driving rising inequality — new technologies and access to cheap labor through increased globalization — may also be driving a sustainable increase in corporate profits. While we may be understandably wary of “this time is different”, consider the following:

The rise of China as a trading partner over the last two decades.

US Imports from China

Corporate profits at 11% of GNP suggest a new paradigm when compared to the historic (normal) range of 5% to 7%.

Corporate Profits/GNP

The decline in employee compensation as a percentage of corporate value added mirrors the rise in corporate profits.

Employee Compensation/Value Added

And Robert Shiller’s CAPE, normally used to argue that the market is currently overpriced. If we stood in 1994 and looked at the range of CAPE values for the past century, we would no doubt have concluded that a CAPE value greater than 20 indicates the market is overpriced. In the last two decades, the CAPE only briefly dipped below 20 at the height of the global financial crisis. Now pundits argue that a CAPE value greater than 25 indicates the market is overpriced. Something has definitely changed.

Shiller CAPE

Whether the change is sustainable, only time will tell. But one thing is clear. Of the 466 corporations who have so far reported earnings for the first quarter 2014, 77% have either beaten (68%) or met (9%) their estimates. Corporate profits are not in imminent danger of collapse.

Is the market over-priced?

In my last post I concluded that the same factors driving rising inequality — new technologies and access to cheap labor through increased globalization — may also be driving a sustainable increase in corporate profits. While we may be understandably wary of “this time is different”, consider the following:

The rise of China as a trading partner over the last two decades.

US Imports from China

Corporate profits at 11% of GNP suggest a new paradigm when compared to the historic (normal) range of 5% to 7%.

Corporate Profits/GNP

The decline in employee compensation as a percentage of corporate value added mirrors the rise in corporate profits.

Employee Compensation/Value Added

And Robert Shiller’s CAPE, normally used to argue that the market is currently overpriced. If we stood in 1994 and looked at the range of CAPE values for the past century, we would no doubt have concluded that a CAPE value greater than 20 indicates the market is overpriced. In the last two decades, the CAPE only briefly dipped below 20 at the height of the global financial crisis. Now pundits argue that a CAPE value greater than 25 indicates the market is overpriced. Something has definitely changed.

Shiller CAPE

Whether the change is sustainable, only time will tell. But one thing is clear. Of the 466 corporations who have so far reported earnings for the first quarter 2014, 77% have either beaten (68%) or met (9%) their estimates. Corporate profits are not in imminent danger of collapse.

Taxes and corporate profits

A secondary element — when compared to wages, raw materials and interest rates — is the impact of a lower effective tax rate [blue line] on US corporate profits (CP/GDP). Part of the post-GFC fall in the effective corporate tax rate can be attributed to tax losses, incurred during the GFC and used to shield current income. Tax savings are likely to be short-lived, with effective tax rates returning to pre-GFC levels around 24%.

Effective Corporate Tax Rate

Wages and corporate profits

Employee Compensation as a percentage of Net Value Added (by US Corporate Business) has fallen sharply since the GFC, boosting corporate profits. Again we can observe an inverse relationship, with corporate profits spiking when compensation rates fall, and vice versa.

Employee Compensation compared to Net Value Added

A sharp fall in unemployment would send wage rates soaring, as employers bid for scarce labor. But that is not yet on the horizon and we are likely to experience soft wage rates until the economy recovers.