previously made. They are about to start shrinking. When? Like right now. Maybe last month, or last quarter, even. What led me to write about this is, believe it or not, is public sector employment. Employees of State, Local and Federal governments are not many, they peaked at 14.68% of the labor force (not including the census high) exactly as private payrolls hit bottom, and hit a trough in June and July 2013 at 14.01% representing 21,826,000 employees. In other words, fiscal drag added 0.67% to the unemployment rate.
But this summer we had three important developments:
- The labor force stopped growing
- The number of public sector employees stopped shrinking and may be growing
- Real average hourly earnings growth of non-supervisory employees accelerated to a level coincident with the last expansion
|Public (blue rhs) and Private employment as % of labor force|
With the private sector labor demand growing, public sector stable, or growing, and labor supply (labor force) stable or shrinking, the only plausible answer is wage growth. And, as the marginal unit of labor required to produce a marginal unit of final output goes up in price, so must marginal profit margins fall. But this is not the most interesting part.
|Capital expenditures / GDP (blue, lhs)|
After-tax profits / GDP (red, rhs)
This, finally, gets me to my much delayed points:
- If the marginal effective tax rate of the household sector is higher than that of the corporate sector, which we know is true because FICA on its own is 15.3% (split by employer and employee), a marginal dollar that moves from profits to wages will increase tax receipts
- If the marginal propensity to consume of households is larger than the marginal propensity to invest of corporates, a marginal dollar that moves from profits to wages will increase aggregate demand
- If the marginal propensity to consume or invest of the public sector is greater than the marginal propensity to invest of the corporate sector, the increase from #1 will increase aggregate demand
- Any savings by households and/or government in excess of investment will be coincident with lower profits, all else equal.*
- Any increase in demand for labor by the public sector in response to #1 (in the form of bigger budgets) will be a marginal pressure to the right in labor demand which, all else equal, will lead to an increase in both the price and quantity demanded at the new price of labor.
- Increases in employment and household income will reduce the cyclical deficit and reliance on government assistance programs like medicaid and "food stamps." This is, once again, an increase in government savings which is negative for profits.
|10y treasury yield minus %YoY change in CPI (blue)|
%YoY change in average non-supervisory hourly wage
minus %YoY change in CPI (red)
|Net Investment / GDP|
Is this a doomsday sign for stocks? Maybe not. It is possible that aggregate demand growth is enough to let profits fall as GDP increases and profits rise more slowly, however, it is not likely in my opinion. Assuming a reversal to mid 2000s effective corporate tax rates of 22% after tax profits as % of GNP to a generous 7% (median is 6.10% and mean is 6.34%) and a NGNP growth rate of 6% (mean 6.11%, median 6.7%, current 3%) over 10 years the CAGR of after-tax corporate profits would not amount to more than 1.65%. But it is also not terrible. GMO likes to flaunt their 1100 "fair value" number and Hussman is partial to his price-to-sales ratio chart, but there is no reason for stocks to fall to their fair value, and every day that passes, their fair value will close in to their present value, and at an accelerating pace. This would make selling short equity a trade with a short lifespan, while other trades--especially those where time works in your favor, like being long high-grade municipal bonds, an asset class which happens to be offering remarkable value--offer much more attractive ways to play the thesis.
Marginal head-winds for employment and wages are turning into marginal tail winds as the economy recovers. These same factors posses self-reinforcing properties and are likely to continue to be positive impulses for, real wages, employment levels, tax receipts, and aggregate demand and negative impulses for corporate profit margins and corporate savings. Favor the liabilities of the household and public sector over those of the corporate sector.
*Going back to Kalecki's Profit equation we can remember that:
Corporate Saving = Profits - Dividends
Profits = Investment – Household Savings – Government Savings – Foreign Savings + Dividends