Stall Speed

The most notable event last week was Friday’s employment report. Updating the data and estimates I presented in Stalling Engines: The Outlook for U.S. Economic Growth, The current labor force now represents 62.8% of the U.S. working age population. That participation rate is below the record high of 67% at the peak of the 2000 economic cycle, but remains several percent above the post-war norm prior to 1980. Civilian employment currently stands at 153.2 million, representing 95.6% of the labor force (160.2 million). The unemployment rate captures the remaining 4.4% of the labor force. Based on demographic factors, the Bureau of Labor Statistics projects the civilian labor force to grow to 163.8 million by 2024. Provided that the unemployment rate holds at 4.4%, employment growth can be expected to contribute just 0.3% annually to GDP growth over the coming 7-year period.

Any additional economic expansion will have to come from productivity growth. Over the past decade, productivity growth has declined from a post-war average of 2% to a growth rate of just 1.2% annually, with growth of just 0.6% annually over the past 5 years. Accordingly, barring any increase in the unemployment rate, a continuation of existing productivity trends would produce real U.S. GDP growth over the coming 7-year period ranging between 0.9% and 1.5% annually. Less likely, though not impossible, would be a full reversal of the slowing productivity trend of recent decades, restoring pre-2000 averages. This would push the prospects for real GDP growth as high as 2.3% annually.

Notably, fully 1.4% of the 2.0% average annual real GDP growth observed since the beginning of 2010 has been driven by growth in civilian employment. As slack labor capacity has slowly been reduced, the unemployment rate has dropped from 10% to just 4.4%. That jig is up. As a result, the U.S. economy is likely to hit stall speed even in the absence of outright recession.

If one assumes an inflation rate of 2% and a steady rate of unemployment at 4.4%, nominal annual growth in GDP and corporate revenues would be expected to average between 2.9% and 3.5% annually in the coming years. Since this estimate rules out the possibility of recession, the resulting growth range would be a modest acceleration from the past decade, when S&P 500 revenues grew by only 1.6% annually, and would be roughly similar to the past 20 years, during which S&P 500 revenues have grown by 3.1% annually. The corresponding average annual growth rates for reported S&P 500 earnings, even including the impact of share buybacks, were 1.9% over the past decade and 4.7% over the past 20 years.

In recent decades, S&P 500 earnings growth has outpaced revenue growth because of an expansion in profit margins, which has been closely tied to the failure of real wage growth to keep pace with even the weak rate of productivity growth (or equivalently, growth in unit labor costs at a slower pace than growth in the GDP deflator). See This Time is Not Different, Because This Time is Always Different for more detail on these relationships. With the unemployment rate now compressed to just 4.4%, we’ve already observed a downward reversal in the corporate profit share of GDP. Just a modest normalization of corporate profit margins by this mechanism is likely to drive S&P 500 earnings growth below zero in the coming years, even if revenues continue to expand, and even assuming no recession whatsoever.

[Geek’s Note: Denoting wages W, prices P, output Q, and labor L, and de-trending to reflect the fact that real wage growth has historically lagged productivity growth by about 0.4% annually, we find that corporate profit margins reliably increase when real wages meaningfully lag productivity growth: %W-%P<%Q-%L-0.4%, or equivalently, when unit labor costs meaningfully lag inflation in the GDP deflator: %W+%L-%Q<%P-0.4%, or also equivalently, when the share of nominal wages to nominal GDP falls rapidly: (%W+%L)-(%Q+%P)<-0.4%. Since weak wage growth tends to be associated with weak household income and savings, coupled with government deficits to stabilize income, we also observe that high corporate profits tend to emerge as a mirror image of high combined deficits in household and government saving].