Corporate profits were strong in 2013, with S&P 500 profits jumping an estimated 11% year-over-year.
With profit margins at record highs, some fear that we are due for some mean reversion, which could mean falling profits and tumbling stock prices.
However, Goldman Sachs’ Jan Hatzius doesn’t believe 2014 will see profits pull back.
“Profits are likely to accelerate in 2014, as GDP and productivity growth recover but wage growth picks up only gradually,” wrote Hatzius in a new note to clients. “Eventually, the pendulum will swing back in the direction of lower profits, but probably not until the labour market has recovered sufficiently to push up hourly wage growth up to 4% or more.”
Let’s unpack this.
To understand his bullish thesis, you have to look back at 2013, a year when profit growth overcame significant headwinds. Hatzius identified three: 1) relatively weak GDP and productivity growth in the U.S.; 2) very weak growth outside of the U.S.; and 3) low and declining inflation.
Despite these challenges, after-tax corporate profits grew an estimated 6.5% using the definition of the national income and product accounts (NIPA).
Here’s Hatzius on the strength:
What accounts for the strength? We believe that the key reason is the continued slack in the US labour market, and the resulting weakness of nominal wage growth. Exhibit 1 shows that our wage tracker–a composite measure based on the three most widely used hourly wage measures–is still only growing at about 2%. This weakness has held down unit labour costs even in an environment of sluggish GDP and productivity growth. And in turn, the subdued growth of unit labour costs has supported profit margins even in an environment of low price inflation…
For 2014, Hatzius expects wage growth to remain modest. Furthermore, he expects the three headwinds mentioned earlier to act as tailwinds:
1. A significant pickup in US GDP and productivity growth. We expect both GDP and productivity growth to accelerate by about 1-1.5 percentage points in 2014 vs. 2013. Exhibit 2 suggests that this acceleration, on its own, should boost corporate profit growth by several percentage points.
2. Better growth outside the US. Our global forecast calls for growth outside the US to accelerate this year. In particular, growth in Europe is likely to accelerate to a trend or slightly above-trend pace. We also expect the emerging world to do a bit better in 2014, although progress there is still likely to be slow.
3. A slight pickup in price inflation. Although inflation is likely to stay well below the Fed’s 2% target, we do expect a slight acceleration in 2014 as the recent weakness in healthcare cost inflation moderates and the output gap diminishes. This should modestly boost topline revenue growth in the corporate sector as well.
4. Only a modest pickup in wage growth. Wage growth is likely to pick up from its recent 2% pace, but probably only slightly. This expectation is consistent with historical norms; a look back at Exhibit 1 shows that wage growth has generally not accelerated quickly over the past few decades (i.e. since the Volcker disinflation of the late 1970s and early 1980s).
Hatzius believes that wage growth will eventually have to accelerate to around 4% before labour costs materially eat into profit margins. But as he has written before, the tremendous amount of slack in the labour market will prevent this from happening any time soon.