It is an age-old debate. What spurs economic growth, higher compensation for the workers in an economy, or higher profits for the employers of those workers? When compensation costs rise, and corporate profit margins compress, is this a good thing for an economy? And vice-versa, should corporate profitability be a priority at the expense of personal compensation? These questions are at the heart of many economic policy debates and have significant ramifications, both ethically and financially. And while these ramifications lie outside the scope of this paper, history shows that this relationship is cyclical and that it is highly probable that there is a symbiotic relationship between these two groups: the toiling proletariat and the entrepreneurial capitalist. Below is a chart of corporate profits and compensation as a percentage of U.S. GDP. As you can see, there is a negative correlation between the two data series. Generally, when worker compensation (yellow line) is declining corporate profits (blue line) are increasing, and alternatively, the opposite is also true. This makes sense since compensation makes up the bulk of a company's cost structure, and it follows that as wages increase, corporate profitability will decline. On the flip side, when compensation is too low, it hurts overall consumption and demand for the very products that those companies produce. Low compensation can also indicate that companies have refrained from hiring and not ready to meet additional demand.
As the above chart demonstrates, employee compensation, as a percentage of GDP, topped out in 1970. It has been declining ever since, and currently resides near 60 year lows. Meanwhile, corporate profits, as a percentage of GDP, are near 60 year highs. The important questions are, one, what has been driving this trend, and two, will this trend reverse? And when it reverses, what are the implications for the market?
The Fundamental reasons for stagnant wage growth
The labor supply/demand curve is the root cause for stagnant wage growth. The working age population increased dramatically post-1970 as the baby-boomer population entered the work force. It is no coincidence that as this cohort reached working age, compensation, as a percentage of GDP topped out. The working-age population increased in the United States from under 56% in 1962 to around 64% by 1990. More labor supply necessitated a drop in wages, or at the very least, a decrease in the pace of wage gains.
Compound the increase in the working-age population, with an influx of female workers, and the supply glut of labor became even more pronounced. The female participation rate during the 1970's increased over 10%, and climbed from under 38% in 1960 to almost 58% by 1990.
As the increase in labor outpaced demand, the negotiating position of workers diminished. Unionization, once a stout force in U.S. politics dwindled. Union rates, or the percentage of workers that belonged to a Union, declined from over 27% in 1960 to around 16% by 1990. It currently resides around 11%. Unfortunately for domestic workers, as the labor supply and female participation rates began to flat-line in the 1990's, U.S. companies found an abundant supply of laborers off-shore. Globalization meant that companies could access foreign workers who were willing to produce at much lower wages. Over the last sixty years, the U.S. economy has been forced to digest an incredible supply glut of labor. The result? Compensation has remained stagnant, and corporate profits have reaped the benefits, and currently make up an over-sized portion of GDP.
The Fundamental Reasons wage stagnation will reverse
Many of the trends that have caused stagnant wage growth in the United States have reversed, or are currently, in the process of reversing. Female participation rates topped-out at the turn of the century and are currently declining. The working-age population topped-out in 2007, and the fastest growing cohort in the United States are those over the age of 65. Workers aged 55-65 (pre-retirement) now make up 12.5% of the population, up from 9% at the turn of the century. It is estimated that over 1.5 million people will reach retirement age each year for the next ten years. Globalization still offers U.S. companies access to cheap labor, but that advantage is also starting to diminish as wage pressures in emerging economies continue to surge. China, the go-to country for cheap labor, has a burgeoning middle class, and wages have risen over six-fold since the beginning of the millennium. The marginal advantage of producing outside the United States will continue to wane as emerging market economies mature.
The secular trend of increasing labor supply has likely already reversed, and the U.S. economy is poised to feel the effects as we transition from a glut of labor supply, to a shortage. What does this mean for the markets?
The most obvious result of a shortage of labor is that compensation costs in the U.S. will rise. There are a number of cyclical indicators that are already pointing towards tightening labor market conditions: unemployment, initial claims, the NFIB Survey, employment cost indices, and JOLT's survey. I will save these indicators for another paper and instead concentrate on what happened the last time compensation increased in terms of its percentage of GDP (1948-1970). The opening chart is below for easier reference.
From 1948 to 1970, compensation, as a percentage of GDP, increased from 52% to 58.5%. Concurrently, corporate profits decreased from 13.4% to 7.7%. How did the corporate sector do over this time period, as operating margins were compressing due to higher labor costs? Corporate Profits managed to grow an annualized 5.4% during this period. This contrasts with an overall growth rate of 7.4% since 1948, and an even higher 8.5% from 1970 to the present. But while corporate profits experienced weaker growth over this period, the stock market actually did quite well. From 1948 to 1970, the S&P 500 Index registered an annual gain of 13.4%. It only registered a 10.2% annualized gain after 1970, when compensation started to decline. Margin compression seems inevitable for corporations during rising wages, however, market returns are predicated on many more variables. First, while corporate profits were accounting for less of GDP, GDP was actually growing at a more robust rate. From 1948 to 1970, Real GDP increased an average of 4.0%. Since 1970, as compensation stagnated, Real GDP growth has averaged 2.8%. A smaller piece of a larger pie can actually be beneficial. Even more interesting is the fact that inflation from 1948 to 1970 averaged 2.4% whereas it has average 4.2% since 1970, making the stock market gains look even more attractive. Higher inflation rates post 1970 are the result of many causes, specifically oil-related spikes of the 1970's. I am not trying to correlate increased worker compensation to lower inflation rates. Textbooks would contend the opposite. I am merely noting that increased wages and declining corporate profitability does not necessarily preclude a robust stock market, nor does it automatically result in inflation.
The labor supply glut that has persisted since 1970 has largely corrected. The secular trend of stagnant wages that has been the result will likely reverse trend in the near future, and could persist for decades. The result will be a decreasing share of GDP for corporate profits, and an increasing share for compensation. If history is a guide, this reversal of trend could result in more robust GDP growth as the consumer reaps the benefits of more disposable income. Corporate profits will be pressured by declining operating margins, however, they will enjoy top-line revenue growth and benefit from a "smaller piece of a larger pie."
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.