U.S. profit margins have widened significantly in the last couple decades. Total U.S. corporate profits as a percent of GDP averaged only about 8% in the 20 years leading up to 2000, but has since risen by almost 30%, averaging 10.5%. Similarly, the overall profit margin among S&P 500 companies has increased steadily in this recovery to record highs!
As illustrated in Chart 1, much of the improvement in U.S. profitability has been due to a record-setting expansion in labor margins. The data for this chart comes from the National Income and Product Accounts which records quarterly GDP. It shows the percent by which U.S. corporate unit sales exceed unit labor costs. Between 1950 and 1999, corporate labor margins ranged mostly between 34% and 38%, but since 2000 they have averaged more than 40%, and since 2004 they’ve ranged between about 40% and 44%!
This prolonged period of margin enhancement, at the expense of labor, may be coming to an end. Political rhetoric focused on a failing U.S. capitalistic system has intensified in the last several years and is likely to be resolved, at least in part, by public policy interventions aimed at reducing labor margins (e.g., raising taxes on corporations and lowering taxes on labor earners). More importantly, while lethargic throughout most of this recovery, wage inflation has risen more forcibly in recent years. Since 2014, U.S. wage inflation has increased from about 2% to 3.3%, and as shown in Chart 1, this has been associated with a 2% decline in labor margins (from 43.5% to 41.5%). Since the U.S. is at full employment, if the economic expansion persists, wage pressures should continue rising.
Many popular investments have benefited from this unprecedented rise in labor margins. Should labor margins continue reverting toward historic norms, however, these previously successful investments may prove disappointing. Consequently, investors should consider how exposed their portfolios are to ‘Margin’ investments.
Labor-Intensive Stock Sectors
Predictably, the stock market sectors most strongly impacted by movements in U.S. labor margins are the most labor-intensive. In order to judge labor-intensity, S&P 500 sectors were ranked by total asset to employee ratios. Those sectors with the lowest asset to employee ratios (i.e., those with the highest labor to capital ratios) were considered the most labor-intensive. Using an average of this ratio during recent years, the top three labor-intensive sectors were Consumer Discretionary, Consumer Staples, and Industrials. Interestingly, the fourth highest average labor-intensiveness in recent years is the Technology sector.
Chart 2 overlays the relative total return performance of the three most labor-intensive S&P 500 sectors with the U.S. corporate labor margin since 1950. Although far from a perfect relationship, there has been a strong link between labor-intensive sector stock performance and corporate labor margins. Overall, the best relative performance from these three sectors has generally occurred when labor margins were trending higher, and periods of poor investment performance were often associated with significant declines in labor margins. Notably, the relationship has been strongest since 2000. Since then, an unprecedented advance in corporate labor margins significantly boosted earnings leverage, causing labor-intensive stocks to frequently lead the U.S. stock market.
The persistent and significant outperformance of labor-intensive stocks, for such a long period, has made them market darlings which are broadly represented in portfolios. But, is the driving force behind their success—widening labor margins—ending? Labor margins have already declined by about 2% from recent peaks, and with inequality at the epicenter of national political discussions and wage costs rising in a fully-employed recovery, won’t labor margins likely contract further in the coming years? Indeed, could labor margins eventually return to their pre-2000 post-war average near 36%? The chance for such a reversal suggests considerable investment risk in these currently popular labor-intensive stocks!
Charts 3, 4, and 5 highlight uncomfortably-close relationships between three popular investment strategies and movements in the U.S. corporate labor margin. In an era of fear after the dot-com and Great Recession collapses, low volatility, high quality, and premium dividend payers have been widely favored by investors for much of the last two decades. As shown, since 1990, each of these investment attributes has enjoyed a favorable underlying foundation of widening labor profit margins. The top four labor-intensive sectors within the S&P 500 index (Consumer Discretionary, Consumer Staples, Industrials, and Technology) comprise significant portions of each of these indexes: the Quality index is composed by almost 70%; Dividend Aristocrats by 58%; and the Low Vol index by 26%.
More importantly, the relative performance of each of these popular investment characteristics has been closely tied to the movement in labor margins. Since 1990, the correlation between the relative performance indexes for these three investment attributes and labor margins ranges between a very strong 0.83 and 0.87!
A unique post-war surge in corporate labor margins since the early 2000s has persistently favored labor-intensive sectors within the U.S. stock market. Many of today’s popular investments are currently tilted toward these beneficial sectors, even though corporate labor margins have been trending lower in recent years, causing some of these investments to begin underperforming.
The contemporary political strife focused on labor’s share, and a recent rising trend in wage inflation, makes it likely that labor margins will continue to diminish in the next several years. Consequently, investors should consider lightening up on popular labor-intensive stocks before they lose their luster.