Economists sometimes look at the shares of labor and of capital in GDP. Labor's share recently has been depressed. And since there are two inputs if one share goes up the other share goes down. In this simple way you can see how corporate profitability and stock prices are linked to events in the labor market.
Unless you live under a rock with no electricity or are a hermit, you are aware of some of the strange features exhibited by the US job market. Job growth has continued to be 'strong' even in this recovery that has become quite long in the tooth. And yet this recovery has been weak and characterized by slow productivity growth and anemic wage growth.
While there are some unprecedented aspects to this situation there are attributes of the recovery that fit together to make this an understandably frustrating recovery for labor that might even explain investors fondness for capital or stocks. However, this has become a finely tuned and balanced process.
Overall growth is slow, so you would expect slow job growth. But since productivity is so weak it takes more workers to generate even slow growth. This leads to the result of weak economic growth coupled with strong job growth - an oxymoron in more normal times. And since productivity growth is weak, wage gains have been low- in a competitive economic system a worker gets paid the value of his marginal product. If it is low, his wage is low. The unemployment rate has declined below what the FOMC thought was a reasonable low and despite that there is still little wage pressure. And now, the drop in the rate of unemployment is starting to slow (see slides for labor trends).
The Federal Reserve is worried that the low unemployment rate will generate inflation as it has in the past. But in this cycle, behavior suggests that there is little tension on wages stemming from tight labor market conditions. Moreover, an aging population has sent an unusual impulse though the labor force data and on top of that age cohorts up and down the line are demonstrating unusually lax participation characteristics, leaving the economy in a situation with less unemployment than it has typically has had given the level of employment and size of the working age population. An argument continues to rage about the 'not-people,' those who are not employed, not in the labor force and yet not unemployed. Why have people in the prime of their working years suddenly dropped out? Do they hover ready to supply labor services or not? Do they matter to wage prices dynamics in the economy? My guess is that they don't; they are an effect of all this, not a cause.
This has led to speculation that we may not measure unemployment correctly and has led some to focus more on the broader U6 rate than the 'official' U3 rate. But it is not clear that those in labor market limbo (not employed not unemployed and therefore not counted) play any role in wage discipline.
Other factors swirl in the background affecting wage-price dynamics because technology has replaced so many workers and many well-paid factory jobs have evaporated. Some are taken by mechanization and some have simply been replaced by cheaper foreign labor. It is digging there that we will find our answers.
Our policymakers have not settled on an understanding of our situation. Because of that they cannot decide on an optimal policy. If technology and trade are constricting wages then labor market tightness might not overwhelm that. If firms see the labor market as a 'global artifact' tight conditions in the US may not matter for wage-setting behavior. Competition would prevent firms from paying higher wages in the US as they would be undercut by lower wage-using competitors overseas. And if productivity stays low, firms will not be able to afford to pay labor any more regardless how tight the labor market gets. Firms will not hire labor at a loss.
Keynesianism under fire!
One aspect of Keynesianism is its belief in bottle necks. Unemployment can't get too low without prompting wage hikes. Capacity utilization can't get too high without prompting price hikes. But times have changed and Keynes' definitions need to be adjusted.
Global competition is a fact of life. Technology and its dislocations are a fact of life. In this environment it's not clear that traditional Keynesian definitions of markets are valid anymore. Does capacity utilization in the US or in Canada or in Europe even matter if there is global slack? Is there only one, global, capacity utilization situation that matters?
In this new world local saturations may not matter much for wages and prices. If the US labor pool is saturated, labor will be supplied from another source or business will go wherever it needs in search of it. With businesses even in services focused on reducing costs and with information technology so highly developed, price hikes are harder to sustain and price discipline even in the service sector has been widespread. Price discipline affects services prices partly because incomes are so firmly held in check. With labor being supplied on the margin out of Asia or from Mexico, or intra-marginally, by being released domestically through the use of technology, firms have had other places to go to find labor or to create output, and wages have stayed in-place. Firms have not had to try to ride up the supply curve on the back of higher wages; nor can they afford it.
As a result, old, dusty, Keynesian precepts have not worked well as policy guideposts. The Fed has been misled by low-seeming unemployment and arguably is tilting at windmills in its fight against coming inflation. What if the Fed continues to hike rates and inflation is not coming?
This is an important scenario for investors to nail down. Is competition truly global? Or is there enough 'local' in output and demand that domestic conditions really do matter? Have we finally arrived in a world in which the 'law of one price' holds across most goods globally instead of just commodities like gold and red-wheat no.2?
These are crucial questions for policymakers and investors. Stocks continue to ramp up on the Fed's (the ECBs and the BOJs…) low interest rate policy but in the US P/E ratios are not well explained by interest rate levels alone. Interest rates may be in the equation but there are other reasons that stock prices are high. So you can breathe a sigh of relief as the Fed gets ready to hike rates again…but don't breathe too freely. Rates could still get to be too-high if the Fed does not figure this one out.
Jobs and stocks are joined at the hip
The weakness in wages and the strength in capital prices suggest ongoing disparities in supply. Asia's development continues and with growth Asia has increasing demands for 'more stuff,' and yet all Asia has brought to the game has been labor. China's insertion into the global economy was like an expansion in the global labor supply. And that goes for other newly developing Asian countries as well. And while Asian labor joined in, it was low wage and helped to depress the global wage rate. In addition Asia did not bring much in the way of new capital at first. Instead, direct foreign investment plowed in to provide it. So China increased the demand for capital and the expanded the supply of labor pushing the return for one up and for the other down. Capital is still trying to catch up to the increase in labor supply and to overall demand. But capital is chasing a moving target.
Asia has introduced other global macroeconomic effects as well. There has been a dislocation of global aggregate demand. By shifting jobs from the West to Asia, of course, the global wage bill was reduced as high wage earning Westerners lost jobs and lower paid Asians took them. That cut demand and consumption. In addition the savings rate in Asia is higher than in the West so the global multiplier is now lower, too. That cut expansion. Asian consumers save more than Westerners do in part because their governments do not offer entitlement systems.
The key to whether this process will continue to function as it has is the way in which Asia continues to develop. Compare it to, say, Latin America. Latin America in the late 1970s was about consumerism. Its growth added to inflation. Its local economies lived and breathed high inflation. Asia is not like that. Asian wages are kept low. China wants more jobs but does not want the living standards to rise too fast. And China is a communist country as we are now being reminded (in case we forgot). So a low-wage high-output model has also helped create this result and to fuel corporate profitability as a side-effect. At the same time this development in Asia has undercut wealth creation in the West where jobs are disappearing and wage growth is held in check reinforcing the high profit low wage scenario. In the US, imports have been financed with debt as the US has run a never ending string of current account deficits financed in part by Chinese purchases of US treasuries. This was a perpetual motion machine on bad fundamentals until the financial crisis hit and now everyone is trying to regroup and to rationalize their role.
The China factor
US deficits continue but with fracking the US is exporting oil and that helps the US balance of payments (where the ink is still hopelessly red). In China's recent 5-Year party Congress, it reaffirmed Communism. China's leaders have seen what the oligarchs did in Russia and as a result China has taken steps to rein in the wealthy. There have been purges of those who benefited from 'corruption.' For our purposes this is an affirmation that China will stay the course and continue on the steady low wage track pulling more people into the developed part of the economy in a measured way. It suggests that China is not going to switch to consumerism and that price discipline will remain in train for the next five years as well, as China works to broaden rather than deepen its development.
Much of the odd-seeming macroeconomic situation we face is about how the economy manages labor and overall demand. This is a process that uses capital and employs technology amid a boost in labor supply conditions. So what would you expect? Technology uncontrolled is able to exert a large influence over the future. No one has yet invented a 'consumer' robot so we can expect mechanization to increase the return to capital and to keep downward pressure on wages. Demand is not recovering. China's ongoing expansion will do the same thing on its new (old) 5-year agenda. We see the impact across most occupational classes in the data each month. In the US with the exception of professional business services and the tiny category of information services (where job growth and wages are exploding) wage trends are muted. The Chinese may be able to manage communism as this continues because it will be offering jobs and a better standards of living than before. But in the US trade and technology have destroyed high-paid jobs and created 'opportunity' in low wage sectors. (Here, son, is your opportunity to work twice as hard and make half as much!). The ascendancy of Donald Trump was largely a reaction to this sort of displacement and perceptions of unfair treatment in the labor market. 'More of the same' will create political instability in the US while China will grow.
With a growing pool of those who are neither working nor unemployed, it should be clear that the answer to the problem is not going to be a new tax policy. As the tax base shrinks the options for taxation do too. The burden on the worker will increase as the population ages and fiscal demands balloon. The solution lies in getting more jobs and better jobs and more people at work. And it is not clear that anyone knows how to do it or is even focused on it.
Republicans are focused on tax policy and Democrats are focused on making income distribution fairer. Job growth is on the lips of every presidential hopeful but how many have any idea exactly what to do? It is much easier to do something with tax policy, rearrange the deck chairs on the Titanic, bask in the cheers from your political base and move on… And while that won't solve problems it will keep the same dynamics in place for the economy. The US can grow and continue to underachieve. But there is nothing in this system that will solve its own problems. The near term risk is the Fed keeps thinking inflation is right around the corner and hikes rates too fast. Absent that, the economy should continue to create a stock market friendly environment. The trick will be realize when the Fed has overdone it and jump off the carousel before everyone else does. While this charade can go on for some time, it can't go on forever. Eventually some of the contradictions will hit real world constraints and blow up, either in the form of an economic event or as a political one that tries to mend an economic problem with a political solution. When that happens the game is over.
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 (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.