- The tightening of the labor market, leading to higher turnover and faster compensation growth, and
- Significant slowdown in labor productivity growth.
Looking forward, we believe labor productivity growth is unlikely to bounce back to the rates seen 10-20 years ago. We expect the labor market will continue to tighten, given the historically low trend in labor force growth in the next 15 years.
With that in mind, we think markets are underestimating the likely impact of these trends on stock prices.
These trends may lead to significant downward pressure on stock prices through four channels:
- Foremost, the surprisingly swift labor market tightening, coupled with unexpected slow productivity growth, will lead to surprisingly low corporate profits.
- This labor market tightening will lead to a faster than expected rise in the federal funds rate as the Fed will try to protect against future inflation driven by labor cost increases.
- Higher interest rates will lower corporate profits through higher borrowing costs.
- Higher interest rates will lower stock market valuations.
The most important of these channels is the effect of the tightening labor market on corporate profits. In Chart 1 we decompose  the growth of real profits for the non-financial corporate sector into three components to demonstrate the impact of labor market tightness and slow productivity growth on profits:
- The market size component of profits primarily captures the gains that are achieved by increasing the scale or quantity of production. Highly correlated with GDP growth.
- The price-wage margins component of profits depends on hourly wage growth relative to the growth in prices of business output. A slower pace of wage gains relative to output price growth contributes to profit growth.
- The Total Factor Productivity (TFP) growth component captures that portion of profits’ growth resulting from a more efficient use of labor and capital as well as effects from product innovations.
Chart 1 – Contribution to Real Profits Growth, 1947-2014 Smoothed Trend
Source: U.S. Bureau of Economic Analysis, calculations by The Conference Board
In recent years, the weak labor market led to a slow rise in real wages, which caused price-wage margins to harm real profit growth less than at any time in four decades. That helped keep profits growing despite low contributions from the TFP and market-size components.
Also worth noting is the period of the late 1990s, when strong real wage growth hurt profits more than any other time in recorded history. However, a positive boost from TFP growth helped mitigate this downside to profit.
Cut to 2015. As the labor market tightens this time around, the price-wage margins component will again detract from profit growth. However, we do not expect a similar boost in productivity.
Another reason to be concerned about the outlook for corporate profits is the fact that it is quite rare for corporate profits in the non-financial business sector to grow continuously for more than six years, which is the length of the current streak (if one assumes that profits are still growing).
In Chart Two we divide the business cycle into three general phases:
- Phase One: Early-mid expansion (green): revenues are growing rapidly, the labor market is not tight, productivity is growing rapidly, and interest rates are relatively low.
- Phase Two: Mid-late expansion (yellow): Revenues are still growing, but profits are declining. During this period revenue growth slows down as pent-up demand is exhausted. The labor market is tighter, labor cost accelerates, and interest rates are higher.
- Phase Three: Revenues recessions (gray): Revenues and profits are declining. These periods overlap, although not entirely, with official business cycle recessions.
The blue and red lines show the gross value added and profits for the U.S. nonfinancial corporate business sector, adjusted for inflation. In the past six years the US economy has arguably been in Phase One. Both revenues and profits have been growing. But as Chart Two shows, a period of constant profits growth of longer than six years is quite rare. A key question: Is this period about to end? In other words, are we on the verge of entering Phase Two, as we did in the late 1990s?
In sum, the impact of the tightening labor market and weak productivity growth on corporate profits and stock prices may still be underestimated by investors. If these trends develop in the way we expect, markets may go through a big adjustment: a yellow warning period followed by gray skies for investors.
Chart 2- the three phases of business cycles, revenues and profits
Note: Green areas represent periods of increasing profits and output; yellow areas represent periods of declining profits but increasing output; and gray areas represent declines in both profits and output.
Source: BEA and the Conference Board