Why the US gilded age is poised to last

Some may be surprised that US stocks took just over 5 ½ years to regain previous highs after the so-called Great Recession compared with the 25 years it took the Dow Jones Industrial Average to recover from the Great Depression.[1]

The losses triggered by the US sub-prime crisis were recouped on 10 April 2013, when the S&P 500 Index climbed back to the pre-Lehman-crash intraday high of 1,576.09 it set on 11 October 2007. Since that April day last year, the bellwether US index had added another 22% by July 31 just gone when it ended at 1,930.67.

Amid some talk that central-bank asset buying is fuelling asset bubbles including stock prices, there is a more fundamental reason why US stocks are at record highs; healthy earnings growth. In fact, profit growth has been so strong that US profits have reached a record share of GDP, at the expense of wages.

The encouraging news for US stock investors is that earnings are poised to grow in absolute terms in coming years as the US economic recovery appears durable, even as some of the forces that have driven earnings growth become less helpful. If there’s any link between profits as a percentage of GDP and share prices, then investors can look forward to more years of a rising S&P 500 Index, for chances are that profits as a percentage of GDP will crack fresh record heights in the coming era.

The US economy could, of course, crumble and retard earnings growth. Some other shock could sink shares. Quantitative easing, which shaves longer-term interest rates, played some role in helping stocks so any rise in long-term yields due to its upcoming end could dampen enthusiasm for stocks. There is no ironclad relationship between stock prices and earnings as a percentage of GDP. Profits can never reach 100% of output so there must be some limit to their rise on this basis against wages, even aside from the political consequences that steeper inequality would inspire to reverse the shift. Analysis that focuses just on earnings doesn’t necessarily take into account what’s already priced into share prices. But overall, if the outlook in coming years is one where earnings rise in absolute and in relative terms, the environment for stocks will be more inclined to be favourable.

At labour’s expense

US earnings have risen in recent years largely because supportive low interest rates and overlooked fiscal stimulus have engendered an economic recovery that has just entered its sixth year.[2] US companies have enjoyed low short-term interest rates since December 2008 because the Federal Reserve was quick to slash the cash rate to close to zero to make borrowing costs out to five years as favourable as possible for business once Lehman Brothers collapsed. To ensure longer-term borrowing rates supported the economy, the Fed embarked on three quantitative-easing or asset-buying programs; from 2008 to early 2010, from late in 2010 to 2011 and since 2012.

In economic terms, these low interest rates made more businesses profitable, reduced company debt repayments and encouraged consumers to spend. As far as the stock market goes, puny interest rates justify higher valuations such as elevated price-earnings ratios. Low bond yields prompt investors to look for higher returns from other asset classes – in particular, they helped property and infrastructure stocks whose bond-like qualities make them proxies for fixed income when yields are negligible. Low rates fanned IPOs and M&A activity that are fuel for stock rallies. They encouraged investors to re-rate mediocre companies to higher multiples. They prompted asset allocators to switch money away from rising assets – in this case, bonds – to stay within strategic limits. Lastly, low interest rates combined with pledges by central banks to keep rates low appear to have engendered a complacency about the outlook that is reflected in low readings on volatility, which in turn helps shares. A more stable outlook for prices justifies paying a higher price for an asset and the price stability attracts other, warier, investors. As the low cash rate has the most powerful spurt for the economy and stocks via its dampening effect on bond yields out to three to five years, the ending of the Fed’s asset-buying in coming months shouldn’t be detrimental to stocks. Any unforeseen jump in the cash and thus other short-term interest rates, however, would be harmful.

On the fiscal side, the boost to the US economy and US stocks is staggering when the sum is totalled over the past five years. From 2009 to 2013, US federal fiscal stimulus amounted to 41% of US GDP in aggregate.[3] This US$7.1 trillion (A$7.5 trillion) equivalent of stimulus at 2014 prices[4] that ranged from tax credits to “shovel-ready” projects helped fill the demand void created when workers lost their jobs and businesses and households focused on reducing their debts rather than spending, even if US state governments reduced the stimulus a touch by imposing austerity policies to meet laws that required budgets to be balanced. The US recovery has been robust enough to survive the austerity imposed by Congress over the past year or so. These cuts and higher tax receipts are expected to help lower the fiscal deficit to below 5% of GDP this year from a peak of 10% in 2010.[5]  

Three other forces that boosted earnings growth are worth mentioning too. The first is that companies engaged in cost-cutting to protect margins. Another is that technological improvements allowed business to become more efficient; in economic jargon, innovation cut the labour intensiveness of production. Goldman Sachs analysis shows that from 1998 to 2011 the ratio of spending on technology to labour grew in auto, oil and gas, communications, mining, retail, wholesale trade and warehousing. The other boost is that globalisation created fresh foreign markets for US companies and eased access to long-standing ones. In 2012, US companies earned 21% of their profits from abroad, triple the 7% share recorded in 1969, according to the US Bureau of Economic Analysis.

These stimulants helped US profits expand at a much faster rate than earnings did in other developed countries in absolute and relative terms – hence the outperformance of US stocks in 2012 and 2013. Minack Advisors says profits at US listed companies surged from about 3% of GDP in 2009 to about 5.5% of output in early 2014, while listed profits in other developed countries have only hovered around 3% of GDP over the past five years.[6]

This jump in US earnings has boosted the share of profits from all US companies to a record 11.1% of GDP at the end of 2013, according to the Federal Reserve Bank of St Louis, compared with an average of about 6.4% since 1947. At the same time that US profits have soared, the percentage of wealth heading to workers declined to 43% of GDP at the end of last year from a peak of 52% in 1969 and from an average of 47% since 1947.[7]

There is one key reason why increased US profits have headed to shareholders at the expense of workers. Labour has lost its bargaining power over the past 30 years as right-wing ideology triumphed and globalisation expanded the pool of cheap workers for hire, and thus lowered wage pressures. Labour’s negotiating power weakened ever more during the Great Recession, when the jobless rate peaked at 10.0% in October 2009 when looking at the most-watched (U-3) measure, or at 17.2% in April 2010, when looking at the wider (U-6) gauge that includes reluctant part-timers and those dropping out of the workforce in despair.[8]

Piketty’s insight

Even after five years of recovery, there’s no sign that US wages are rising in real terms, let alone relative to GDP, even though the most-watched jobless rate was 6.1% in June just gone, when the wider unemployment measure stood at 12.1%. This wage stagnation reflects job insecurity and the fact that many middle-class jobs have been replaced with poorly paid, even part-time or temporary, ones. Fed Chair Janet Yellen in April even remarked on the “historically slow pace” of wages growth in this recovery.[9]

Even if wages were expanding at a pace to trouble inflation, it would be hasty to assume – as fans of mean reversion seem to – that somehow US profit share will drop towards its long-term average, or even lower. There’s no automatic force in play that returns the profit and labour ratios to GDP to some fairer equilibrium. Outside of wars and other such catastrophes, financial or otherwise, that destroy wealth, only human endeavour that coalesces into a political force capable of effecting changes in labour’s favour can eat away at profits’ share in GDP.

The money in US politics that buys the rich a veto over threats to their wealth, recent Supreme Court decisions empowering the political power of this cash, another high-court decision that eroded the ability of unions to collect fees from all the workers they cover, the weakening of minimum wage standards at state level even amid a push to raise the federal minimum hourly rate and the ability of business to get away with underpaying staff are just some of the forces suppressing wages growth and wages’ share of GDP in the US. The probability is high that Republicans will regain control of the Senate and hold the largely gerrymandered House of Representatives in Congressional elections in November. These results would only add to the power that capital has enjoyed over labour since the early 1980s no matter which party controlled Congress or the White House.

On top of these political pressures, workers face a sub-par economy – it expanded at an annual pace of about 2% in the first six months of 2014. For an historical perspective of how the pace of economic growth affects the relative splits of wealth and income between capital and labour, investors can turn to the book by French economist Thomas Piketty Capital in the Twenty-First Century, an analysis of inequality that is topping best-seller lists.[10]

Piketty has tracked inequality since the 18th century by looking at the breakup of wealth and income across key western societies. His findings on the US show that the recent political shift in favour of capital is pushing inequality towards its peak in 1910 for capital[11], when the top 10% owned 70% of wealth, and its highest for income[12] which was around 2007, when the top 10% earned just under 50% of income. (Income’s previous peak was in the late 1920s. Inequality fell over the middle of the 20^th century because world wars, a Great Depression and government intervention in the form of higher taxes and increased welfare payments made for a more egalitarian society.)

Piketty’s central thesis, which is grounded more in observation than theory, is that the returns flowing to the owners of capital grow faster than GDP and this fact means that capitalism’s natural state is one where inequality rises. Over time, the return on capital is, say, 3% to 7% (profits, dividends, rent, etc.) versus about 1% to 2% for economic growth (and thus wages). Other things being equal, the slower the economic growth, the faster inequality rises. “It is an illusion to think that something about the nature of modern growth or the laws of the market economy ensure that inequality of wealth will decrease and harmonious stability will be achieved,” Piketty says.[13]

The US outlook is only one of modest economic growth – the recovery is robust enough to survive a decline in fiscal stimulus and less promiscuous monetary policy. No political forces are marshalling to tilt laws or regulations in labour’s favour. Therefore, capital’s saunter to a second Gilded Age appears unhindered for now. That’s better news for investors in US stocks than US workers in coming years.

Financial information comes from Bloomberg unless stated otherwise.

by Michael Collins, Investment Commentator at Fidelity

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