CHART OF THE DAY: The Most Important Driver Of Profit Margins

One of the hottest debates among experts covering the markets and the economy is over the sustainability of record high profit margins.

Goldman Sachs’ Jan Hatzius offered his forecast for margins in his “10 Questions for 2014” note.

“Will profit margins contract?” asked Hatzius. “No.”

“As shown in Exhibit 10, the most important driver of profit margins is the gap between price inflation and unit labour cost inflation,” he added. “When prices grow faster than unit labour costs, firms typically manage to raise their profit margins, and vice versa. In our view, the price/ULC gap is likely to move back into slightly positive territory in 2014.”

Hatzius expects wage growth to stay low at least in the near-term.

“[T]he underlying trend calculated from the three primary measures of hourly wages — average hourly earnings, the employment cost index, and compensation per hour — is still only growing 2%,” added Hatzius. “Going forward, we expect only a modest acceleration to perhaps 2.5%. Meanwhile, we expect productivity growth to reaccelerate to 1.5%-2%. Together, these numbers imply unit labour cost growth of 0.5%-1%, which would be slightly below the rate of price inflation of 1%-1.5%.”

Labour market slack is one of the main reasons why economists believe inflation will stay low for a while.

But getting back to profit margin dynamics, we know that wage growth is only part of the story.

“Of course, the price/ULC gap is not the only driver of margins,” continued Hatzius. “But other factors are also likely to look reasonably friendly. We expect foreign profits to improve in 2014 as the global economy gathers some momentum, and see no major changes in corporate income taxes or financial profits.”

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