Wage inflation is back. And it couldn't be showing up at a worse time.
Thanks to wage inflation, the slice of the national income pie going to corporate profits, which has been growing steadily since 2001, looks like it has peaked. And it has peaked at a time when economic growth is slowing.
Together, these two trends could mean an end to the string of 18 consecutive quarters of double-digit earnings growth for the
S&P 500 Index
that has underpinned the stock market's recovery from the crash of 2000.
And there's no quick fix available to the policymakers at the
who set interest rates.
Count this as just one more uncertainty, one more thing to worry about -- along with interest rates, economic growth, the dollar, oil prices and inflation -- in 2007.
Nearing the Peak
The Commerce Department breaks down national income generated by the U.S. economy into slices. There's one for corporate profits, for example, and another for wages and salaries. Those slices of the national income pie vary in size over time.
The slice going to corporate profits, according to the figures that Commerce released on Sept. 28, climbed to 13.6% in the first half of 2006. That's the biggest slice of the income pie going to corporate profits since 1950. In only one year since the Commerce Department started to keep these accounts in 1929 has this slice ever been larger, and that was 1942, when corporate profits accounted for 13.8% of the pie.
This is the stock market's "pie problem." Whatever your take on what the corporate slice of the pie should be, at 13.6% we're clearly near the peak of a 77-year cycle -- excluding the Great Depression years -- that has seen profits range between a 13.8% share of the national income pie and 7.3% (in the not-so-great economy of 1981).
A growing economy makes the pie bigger for everyone, workers and corporations alike. But the good times aren't always shared equally.
In the current economic recovery, between 2000 and 2005, the U.S. economy grew by 12% in real terms. (That's after subtracting the effect of inflation.) During those same years, the share of the national income going to corporate profits climbed from 9.3% in 2000 to the current 13.6%, while the share going to wages and salaries fell from 54.9% in 2000 to the current 51.8%. As a result, even as the economy grew by 12%, the median hourly wage rose by just 3%.
Some economists believe that looking at total compensation, which includes items such as health benefits, is a better measure of a worker's slice of the pie than wages alone. But even that wider measure shows a drop from 65.7% of the pie in 2000 to 64.2% this year.
There are a lot of causes for the very sluggish growth of wages and the relatively rapid growth -- from near the bottom of the cycle to near the top -- in the slice of the pie going to corporate profits:
- Outsourcing of jobs from the U.S. to countries with lower labor costs.
- Corporate downsizing and restructuring that laid off or fired higher-paid workers first.
- Competition with lower-paid workers in an increasingly global economy that pressured U.S. workers to accept lower pay in order to preserve their jobs.
- Government policies that weakened the bargaining power of labor unions in the U.S.
None of these trends has ended, but the pace of change seems to be far more moderate than it was five years ago. So, for example, while union membership was still far lower in 2005 (at 12.5% of the work force) than it was in 1983 (20.1%) or 1990 (16.1%), the decline has slowed. Membership stayed steady at 12.5% in 2004 and 2005, according to the Department of Labor.
Wages in the huge low-cost labor markets of India and China still lag well behind those in the U.S., but wages for skilled workers in India have climbed by 12% to 15% a year, compared with 2% to 6% wage inflation in Western economies.
A Swing Back?
All of which means that the recent uptick in wage inflation in the U.S. economy may not be just the phenomenon of a few months but a sign of a swing in the national income cycle back toward wages. A 3.8% third-quarter increase in unit-labor costs (which subtract productivity gains from any wage increases) sent the year-over-year rate of increase up 5.3%.
That would mean another source of pressure on corporate profits besides energy and raw-materials costs -- a big source of pressure, since wages represent by far the biggest variable cost at most businesses.
The recent numbers on wage inflation are shockingly large if you remember that not so long ago unit-labor costs were actually tumbling. In 2003, for example, unit-labor costs fell in three of the year's four quarters -- by 1.7% in the second quarter, 5.5% in the third and 0.8% in the fourth -- and climbed by only 1.2% in the remaining quarter. No wonder inflation was a very low 1.9% that year, according to the consumer price index. As recently as the fourth quarter of 2005, the year-to-year increase in unit-labor costs was just 1.6%.
of the shift from barely noticeable to shockingly fast increases can be attributed to a big decline in U.S. productivity growth in the third quarter to an annual 1.3% from 2.7% as recently as the third quarter of 2005.
The combination of slowing productivity gains and climbing unit-labor costs deeply worries the Federal Reserve. The Fed's formula for calculating the maximum potential economic growth that keeps inflation acceptably low is the sum of population growth (1% annually) and productivity growth. If productivity drops from 2.7% to 1.3%, then the low-inflation growth rate for the economy falls to 2.3% annually from 3.7%. (The first preliminary numbers for third-quarter GDP growth came in at 1.6%, slower than the optimum growth rate.)
The Fed's Dilemma
So the Federal Reserve could be facing higher inflation and slowing growth at the same time. If it fights higher inflation by raising interest rates, the economy slows further. If it fights slow growth by cutting interest rates, inflation climbs faster.
That same combination worries investors, although they would pose the question differently from the way the Fed does. Is the growth of the whole pie slowing, and is the slice of the pie presented by wages growing enough to push corporate earnings growth below the double-digit mark?
The official numbers say no. Standard & Poor's projects earnings growth of 9.9% for 2007. Since earnings projections almost always understate actual earnings by a couple of percentage points, investors would be looking at another year of double-digit earnings growth, on the basis of current projections.
That would be good news for stocks. If you assume 11% earnings growth in 2007, the S&P 500 Index is undervalued at recent prices near 1,364. Using that kind of earnings growth rate and something like the current price-to-earnings multiple on operating earnings per share for the index, in fact, indicates that the index is undervalued by about 13.6%. Don't know about you, but I'd jump at a return of 13.6% for 2007.
Little Faith in the Numbers
But since stocks are currently struggling to go higher, it's safe to say that a significant percentage of investors don't believe the official numbers.
Cut earnings growth in half to 5.5% -- thanks to slower growth in the economy and a reduction in the slice of national income going to corporate profits -- and the story looks very different.
If you assume that the market's price-to-earnings ratio stays the same while earnings growth is cut in half, investors are still looking at a 10% gain in 2007. However, holding the P/E ratio steady is unlikely if earnings are falling. And if the P/E falls in proportion to the drop in earnings growth, the gain for the year turns into a loss of 7.2% in 2007.
It would take only another 2% climb in the S&P 500 Index from here to just about equalize the potential gains and losses in 2007 from my 5.5% earnings growth scenario. And there's nothing like an equal balance between potential losses and gains to freeze a market dead in its tracks.
And that's exactly the scenario investors could be looking at by the beginning of 2007: a balance of potential gain and potential loss that leaves most investors without a good reason to put more cash to work and drive the market higher.
This is all "what if?" at this point. The truth is, investors don't know how strong any of these trends will be in 2007. Will wage inflation continue at its current accelerated rate or drop back to prior levels? Will the slice of the pie going to corporate profits fall back toward historical levels or stay elevated? Will lower oil and other raw-materials prices counterbalance the rise in wages?
And most important of all, what will the Federal Reserve do if it is confronted by a combination of unacceptably high inflation and uncomfortably low economic growth?
I continue to look at 2007 with trepidation. The year ahead is extremely hard for investors to read, and the balance between risk and reward is, at best, balanced.
There is a way out for investors, though. The economies of the rest of the world are increasingly out of sync with the U.S. economy, so the best way to make a buck in 2007 may be to put your money into foreign stocks.
New Developments on Past Columns
Learn From the Market's Fears: On Oct. 23,
reported earnings of 94 cents a share, a 14% increase, for the third quarter.
It takes some juggling to get Amgen's earnings into exact correspondence with Wall Street estimates because the company lowers its earnings to account for stock-option expenses, and Wall Street analysts still don't. But my calculations show Amgen beating Wall Street estimates by 6 cents a share. Revenue climbed 15% for the quarter from the third quarter of 2005.
More importantly for the stock's future price, the company raised its forecast for total 2006 earnings to the range of $3.85 to $3.95 a share from an earlier range of $3.75 to $3.85. The consensus of Wall Street analysts called for earnings of $3.83 a share.
As of Nov. 7, I'm going to stick with Amgen a little while and raise my target price to $81 a share by March 2007 from my prior target of $78 by October. The stock is likely to be a boost from the Sept. 27, 2006 approval of Vectibix, a drug for colorectal cancer that has spread to other parts of the body following standard chemotherapy. In the short run, news that CERA, a competitor to Amgen's Epogen, a drug that encourages red-blood cell production in patients suffering from chronic anemia, is now likely to launch in the second half -- instead of the first quarter -- of 2007.
At the time of publication, Jim Jubak did not own or control shares in any of the equities mentioned in this column. He does not own short positions in any stock mentioned in this column.
Jim Jubak is senior markets editor for MSN Money. He is a former senior financial editor at Worth magazine and editor of Venture magazine. Jubak was a Bagehot Business Journalism Fellow at Columbia University and has written two books: "The Worth Guide to Electronic Investing" and "In the Image of the Brain: Breaking the Barrier Between the Human Mind and Intelligent Machines." As an investor, he says he believes the conventional wisdom is always wrong -- but that he will nonetheless go with the herd if he believes there's a profit to be made. He lives in New York. While Jubak cannot provide personalized investment advice or recommendations, he appreciates your feedback;
to send him an email.