Lofty corporate profit margins — and their seeming reluctance to return to their longer-term averages — last month had Goldman Sachs Group Inc. wondering about the efficacy of capitalism.
But fresh analysis from Goldman's Elad Pashtan's is sure to instill renewed faith in the Invisible Hand for any of his colleagues that had had begun to have creeping doubts. Corporate profitability is in fact poised to fall, he warns.
Better yet (at least for the average worker), Pashtan asserts that this decline in profit margins will be driven by employees gaining at the expense of Corporate America.
"We may be on the cusp of a more broad-based margin squeeze," he wrote. "Our model of National Income and Product Accounts suggests a moderate decline in 2016-2017 as stronger wage growth is likely to redistribute income away from capital owners and back toward labor."
Profit margins have edged down in recent years but this has been driven primarily by lower oil prices and the rise in the U.S. dollar, which weighed on revenues that multinationals generated abroad. Ex-energy, the profit margin for S&P 500 companies is down only a tick since the third quarter of 2014, he notes. Lower energy prices are a boon to many industries in which oil is an input cost, but this appears to have been offset by the adverse effect the greenback's gains had on top-line performance.
But human capital dwarfs energy inputs as a share of gross output, Pashtan observes, and real wage growth is expected to be positive over the next few years due to the lack of slack in the labor market.
"The interdependency of compensation and output suggests a close link between wages and profit margins," he finds. "Indeed, as wages accelerate above core inflation — a proxy for output prices — profit margins have correspondingly declined (assuming no changes in labor productivity)."
"We expect this gap between prices and unit labor costs to continue to be a key driver of domestic U.S. corporate profitability," he predicts.
Goldman expects corporate after-tax profits to fall to 8.2 percent of gross national product in 2017, down from an estimated 8.5 percent in 2015, primarily attributable to the tightening labor market.
"As the business cycle progresses and the labor market tightens, workers gain more bargaining power and demand higher wages. Firms — eager to protect their profit margins — raise prices, increasing inflationary pressure," Pashtan explains. "As inflation rises, the Fed reacts by hiking interest rates, dampening price pressures but also sending the economy into recession."
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