At the start of the month we focused on what is set to soon be the new buzzword in economic circles: staglation. Specifically, we referred to the the explicit and inverse correlation between corporate profits and employee wages. As we showed, in the chart recreated below, if indeed labor income, i.e., wages, are rising, then profit margins have no choice but to fall even more; this means that if the stock market wishes to continue rising even higher in a time when wages are supposedly increasing, it will only achieve this with margin expansion, which however can only be achieved by even more Fed intervention and more stimulative inflation, which then pushes wages even higher generating a self-defeating feedback loop.
Yesterday Deutsche Bank picked up on this theme and in a note titled "A New Impossible Trinity", not to be confused with China's impossible trinity according to which, policymakers cannot simultaneously achieve fixed exchange rates, cross-border capital mobility, and independent monetary policy, it says that "America’s ongoing labour productivity slump has created a new impossible trinity – policymakers can only choose two of the following three desirable outcomes: higher nominal wage growth, steady inflation and high corporate profits."
At its core the thesis has to do with the secular decline in US productivity and sliding nominal wage growth. As DB explains "the theory behind this new ‘impossible trinity’ is intuitively simple. If workers’ wages rise faster than their productivity, the companies paying those higher wages face two choices. They can either pass on the extra costs to customers, thereby leading to higher overall prices and rising inflation, or they can absorb the extra costs resulting in lower profit margins. Or in economist speak, increases in nominal wages must equal the sum of productivity improvements, price rises and changes to labour’s share of output (which is the flip-side of profit margins)."
This interaction is shown in the chart below:
DB further notes that for the entire second half of the last century, growth in nominal wages tracked the sum of productivity growth and inflation while leaving labour’s share of output largely unchanged. However, the first decade of this millennium saw nominal wages failing to rise sufficiently to compensate workers for rising prices and their productivity gains. The result was a substantial decline in labour’s share of output through the decade of the 2000s.
This is also the primary complaint about the Fed's policies, namely that in seeking to boost the stock market, policymakers have ignored the lack of wage growth.
DB then recreates the chart we first show above, noting that labour’s share of output is just the flipside of corporate profit margins. And for a quarter century or so after 1970 profit margins of companies remained range-bound, mean-reverting around their average of 7.5 per cent. However, the sustained decline in labour’s share of output which started in the mid-1990s lead to a corresponding increase in profit margins, taking them to a record 12.5 per cent in 2012.
The summary:
The impossible trinity framework also helps explain the reversal of this trend in the last couple of years. Even as companies have enjoyed a Goldilocks scenario of low commodity prices, modest wage pressures and rock-bottom interest costs, corporate America is still somehow mired in what is sometimes called a ‘profit recession’. That is because even though nominal wage growth has been weak by historical standards, it is still outpacing the combination of even lower inflation and historically low productivity growth. Therefore, the labour share of output has actually been rising since 2014, resulting in corporate profit margins declining by two percentage points from their 2012 peak.
What does this mean for the US economy? The optimistic scenario is that productivity rebounds and all returns back to normal. However, DB is skeptical:
The sheer scale of the current slump raises the awkward possibility that a productivity recovery might not come about as expected. A case in point is the data pertaining to the recently concluded first quarter of 2016. While employment growth continued to be strong, monthly payroll additions averaging over 200,000 jobs, forecasts of output growth during the quarter remain subdued. In particular, the Atlanta Fed’s real-time estimate is now for merely 0.1 per cent annualised output growth. The combination of strong employment and weak output growth looks likely to register yet another quarter of very weak productivity growth. Also note that Congressional Budget office recently downgraded its projections of potential productivity over the next decade.
The conclusion:
The point though remains, the cost of lower productivity growth has to be picked up by someone in the economy – by workers in the form of lower growth in real wages and living standards, bond holders in the form of higher inflation or stock investors in the form of lower profit margins. Hence, when forming their assessment of possible future outcomes, investors should bear the impossible trinity framework in mind. An economy stuck in a low productivity growth rut cannot enjoy high nominal wage growth, reasonable inflation and steady corporate profits all at once. Some things are just impossible.
So which will it be: a rebound in corporate profits, a critical precondition to new market highs (unless central banks want to expand PE multiples even more), or rising wages, while keeping inflation constant. Because the Fed can't have all three.