From the mid-1970s into 2007, the two series were highly correlated at 75.8%, with trend productivity leading profits by four years. Since 2007, the two are inversely correlated at the 53.3% level.
Clearly, profits have remained elevated despite weak trend productivity, which begs the question—how did profits hold up in the face of falling productivity? What has occurred is that relative labor compensation has fallen.
The upper line on this chart shows pre-tax profits as a percentage of GDP. The lower line shows labor’s share of output along with a time trend calculated from 1947 to 2004. From 1947 through 2004, the share held fairly steady; although there was a clear downtrend, the slope was fairly benign. Clearly after 2004 the share fell well below trend, and the labor share plummeted after the GFC. It has recovered some of its losses since 2015 but the data is still well below trend. A falling share to labor has allowed firms to overcome weak productivity trends and retain high margins.
Why has labor’s share of output declined? The media discusses a litany of reasons…technology and globalization have given firms market power over labor and allowed companies to keep wages contained despite tightening labor markets. Although this condition has been a boon for profit margins, it has been difficult for workers and we suspect the rise of populism is a direct result of wage pressures.
As the first chart shows, because of the lagged effect of trend productivity, the effects of weak productivity will become acute starting around mid-2018. Without a decline in the labor share of output, profit margins will come under growing pressure. Using a simple regression of trend productivity and labor share, to maintain pre-tax profits of 12% would require the labor share to fall to 55% by the end of 2018. If the labor share remains constant, profit margins will decline to 9.6% of GDP. This level is still historically high but, given market expectations of continued strong profit margins, even this decline will be problematic.
The Trump administration continues to straddle the line between a traditional GOP stance that favors business and capital and a populist variant that calls for trade protection and immigration restrictions. If President Trump decides to favor his working class supporters, which would likely boost the labor share, profit margins would come under even more pressure. This is a factor we will be monitoring closely as the year progresses.
1 P(L, K) = bLαKβ, where: • P = total production (the monetary value of all goods produced in a year) • L = labor input (the total number of person-hours worked in a year) • K = capital input (the monetary worth of all machinery, equipment and buildings) • b = total factor productivity • α and β are the output elasticities of labor and capital, respectively. These values are constants determined by available technology.
This article is courtesy of Confluence Investment Management, a participant in the ETF Strategist Channel.
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This report was prepared by Confluence Investment Management LLC and reflects the current opinion of the authors. It is based upon sources and data believed to be accurate and reliable. Opinions and forward looking statements expressed are subject to change. This is not a solicitation or an offer to buy or sell any security.