Productivity, “reindustrialisation” and the US profit share | FT Alphaville

Productivity, “reindustrialisation” and the US profit share

US industrial production has grown at least twice as fast as GDP since the start of the recovery.

Onshoring” work because wage differentials are narrowing plus falling electricity prices because of shale gas = more growth, so… great! Maybe?

You can argue about whether any of this is certain, and indeed whether the “reindustrialisation” of the US is happening at all. Goldman’s Jan Hatzius says much of the apparent strength of US industrial production is due to the base effect, whether comparing manufacturing with more lacklustre parts of the US economy, or comparing with lacklustre growth and productivity in other developed economies:

Outside the goods-producing sector, US real GDP has grown just 0.5% (annualized) since the start of the recovery in the middle of 2009, by far the slowest rate of any postwar cycle. And of course, the gap between US and foreign industrial output mostly reflects the weakness in Europe and Japan following the intensification of the European financial crisis and the Japan earthquake in early 2011. There is also no sign that the long-standing US productivity and unit labor cost advantage shown in the official cross-country data has led to an improvement in US export performance, defined as changes in US export market shares.

Morgan Stanley’s global cross-assets strategist and general bear Gerard Minack says if reindustrialisation is happening, it won’t be good for profits or, in turn, for equities. And even if it’s not happening, Minack reckons the recent levels of US corporate profitability aren’t sustainable (reported earnings growth has not been entirely stellar, but the share of GDP going to profits is at a level not seen for many decades, and this has contributed to bullish equities markets).

First, the reindustrialisation scenario:

Most see the prospect of America reindustrialising as bullish. In my view, that depends on whether you are an economist or whether you are an investor. The “deindustrialisation” of America was bad for economic growth, but the increased global supply of labour lifted margins and total profits. The effect of wider margins on profits far outweighed the effect of two weak US GDP cycles (the cycles following the 2001 and 2008-09 recessions). Reindustrialisation may reverse this mix: Economic growth may improve, but margins worsen.

Minack makes the point that the reindustrialisation theme gets painted as some kind of saviour of everything, when its effects — in this case, on profits and thus on equities — are far from certain.

His overall argument here is no doubt controversial, but bear with us because it’s interesting and there are some great charts. Like this one, which Minack uses to point out that the US hasn’t really deindustrialised anyway:

US manufacturing & international comparison - by value added - Minack, Morgan Stanley

However it doesn’t feel so great from within the US economy, where manufacturing has fallen as a share of GDP — as with every other big, developed country:

Manufacturing's share of GDP - various countries - Minack, Morgan Stanley

Minack’s argument is twofold: firstly, if “reindustrialisation” is really a thing, then it will curtail record levels of US corporate profitability. If reindustrialisation is just some pleasant narrative without any meaning, those profit levels (and consequently, equity returns) are probably coming down anyway.

Key to this argument is that falling labour costs have been the biggest single contributor to recent corporate profit growth:

US corporate non-fin unit costs (labour, interest etc) - Minack, Morgan Stanley

But how has labour’s falling share of GDP *not* managed to damp down profits, through reduced household spending power? Minack identifies two key trends of the past 25 years or so: more international labour price arbitration, and reduced household savings enabling people to keep spending, despite earning less. The first point — essentially, offshoring wages — is demonstrated well here:

Exhibit 6 shows how the profit share historically tracked the relative utilization of American labour and capital. (The former is measured by the unemployment rate; the latter measured – admittedly imperfectly – by the Fed’s series of industry-wide capacity utilization.)

Profit share compared with implied labour utilisation rate - Minack, Morgan Stanley

Minack’s other point, about households drawing down on savings, probably doesn’t need much explanation. That’s what helped keep sales fairly bouyant; and clearly households are less keen on reducing savings these days. But sales are the smaller part of the equation, compared with margins:

composition of US profit growth - Gerard Minack morgan stanley

It’s more productive labour, whether through lower wage costs (domestically and offshore), improved technology, a better skilled workforce or whatever other mysterious agents (aka total factor productivity) that have helped boost margins.

Why then, would this mostly productivity-derived profit growth be coming to an end? Despite what we hear about Chinese wage inflation, international wage arbitrage still has plenty of life in it. And the stubbornly high US unemployment rate makes it very unlikely that domestic labour will have better bargaining power any time soon.

Despite all this, though, productivity — as measured by the labour cost of a unit of GDP — is no longer improving. Goldman’s Kris Dawsey points out that the mid-1990s to the mid-2000s were an era of strong productivity growth, but it’s slowed since then:

During the 1947 to 1973 period, labor productivity growth averaged about 2.8%–a rapid rate compared with subsequent decades. From 1974 to 1995, productivity growth declined to an average rate of 1.4%. While the causes of this decline remain subject to debate–perhaps due to supply side shocks such as the 1970s oil crises, the entry into the labor force of inexperienced baby boomers, or other factors–economists generally agree that the trend rate of productivity growth shifted down starting around 1973. Beginning in the mid-1990s, productivity growth again rose–averaging 3.1% from 1996 to 2004–in large part due to the IT revolution. Most recently, productivity growth seems to have slowed anew, averaging about 1.6% since 2005, although this is still slightly better than the 1974 to 1995 average pace.

Productivity US phases Goldman Dawsey

(Productivity can be tricky and there’s a whole other debate about whether this slowing is a new trend or not, so it’s worth reading the full note in the usual place; Minack’s is also there.)

The “reindustrialisation” theme is probably something of a red herring; this is more about the vagaries of productivity and distribution. If productivity growth is already slowing it stands to reason that profits will hurt (if indeed productivity has been a big contributor to profits’ growth). Especially when there is little prospect of a new wave of household credit to offset falling margins with higher sales.

Related links:
Do economic fundamentals underpin peak equities? – Gavyn Davies
Recovery in US Is Lifting Profits, but Not Adding Jobs – New York Times
The Insourcing Boom – The Atlantic