The profit story part 1. Will labor costs challenge profit growth?

Jun 20, 2018 by Gary Gordon

The profit story part 1.  Will labor costs challenge profit growth?

 

This blog is all about helping you best manage your investment asset allocation between stocks, bonds and cash.  Stocks are the major asset, and the biggest creator of value over the long run, so your stock weighting is therefore your most important decision.  Don’t worry, you aren’t alone with this decision.  I’m here to help.  What a relief, huh?

My philosophy training (Colgate, 1974) taught me to start with the fundamentals, which for stocks is: What drives changes in their values?  Primarily changes in business operating earnings per share (EPS), as this chart makes clear:

 

Sources: S&P 500 stock index – Yahoo Finance.  S&P 500 EPS – Standard & Poors.

A company’s environmental record?  Its hiring diversity?  CEO’s pay?  Private plane brand?  All interesting to us as citizens.  And all irrelevant to us as investors unless they materially influence profits.  

In turn, what are the key drivers of profits?  Many thousands of people, including me at one time, were occupied in answering this question.  Like any other questions about human activity, there is no single answer.  But we do know the biggest driver of profit growth – economic growth, as this chart shows:

 

Sources: Bureau of Economic Analysis (BEA).

Down the road I’ll give you my theories about economic growth, both secular (long-term trend) and cyclical.  But for now, let’s focus on the non-GDP drivers of profit growth.  Note in the chart above that profit growth lagged GDP growth for most of the 1980s, but since then significantly outperformed GDP.  Underlying that fact are some interesting and important stories for you the investor.  I'm going to explore these four stories over the coming weeks:

  1.       Labor costs
  2.       Industry concentration
  3.       The Amazon Syndrome
  4.       Government tax and regulatory policy

I begin with labor costs.

That darn payroll

Yes, we employees – OK, not me, I’m a retired bum – are the soul of our companies.  We are the innovators, manufacturers, sellers, party planners, etc.  But where profits are concerned, the less of us the better, and the less we get paid the better.  This chart shows that profits and labor costs have an almost perfect inverse correlation (A -73% R², for you statistics nerds):

 

Sources: BEA

Identifying where labor costs are going is therefore clearly very important for making a profit forecast.  Looking backwards, the chart above shows that labor costs squeezed profit margins during the 1970s and 1980s, but added to profit growth since then.  Since answers to my questions just lead me to more questions – until I exhaust myself and need a nap – the next question is why labor costs dragged on profits 30 years ago but have benefited them since.

The answer lies in an economic theory that actually works a lot in practice – supply and demand.  The theory explains the decline in labor costs since the mid-1980s as some combination of rising supply of labor and/or slowing demand for goods and services.  The demand side story worked – secular (8-year rolling average) GDP growth slowed from about 3% in the 1980s to about 2% today.  But the supply side seems contradictory – secular labor force growth in the US fell steadily from 3% in 1980 to ½% today.  Shouldn’t slowing labor supply have raised prices?

They didn’t because, as we know, US companies in the 1980s began aggressively accessing non-US labor, big-time.  Why pay a US factory worker $15 an hour plus benefits when an overseas worker would accept $2 an hour with no benefits?  This trend showed up in the US trade deficit, which as we are now being reminded hourly rose sharply over the past three decades.  And in fact this chart shows that the rising trade deficit correlated nicely with labor’s falling share of national income:

 

Sources: BEA

Looking forward – Are labor’s fortunes looking up?  And profit’s fortunes, well, looking down?

That seems like a reasonable conclusion, based on these facts:

  • Despite outsourcing, the US unemployment rate is down to 3.8%.  That is near an all-time low.  Shortages are being reported in trucking, construction, seasonal workers, etc.  Luckily, we have an ample supply of mimes and hedge fund managers.
  • Demand for goods and services remains solid, particularly with help from lower taxes (i.e. increased government borrowing).
  • The available supply of labor to US companies is under pressure from new government immigration policies…  Some existing workers are being exported, and potential new workers being prevented from entering.
  • …And new government trade policies.  I can’t be the only one who’s noticed that the US is raising tariffs, pressuring US companies to hire locally and challenging existing trade agreements.  You’ve read about it too, right?

That’s a lot of reasons for labor to regain share of national income as a percent of profits.  This chart gives evidence that the trend shift has already begun:

 

Sources: BEA

Conclusion – Rising employee costs appear to be a threat to business profit growth, and therefore to stock prices.