Sent: 09-06-2010 09:50:27
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Getting Companies to Employ
The job of companies is to increase profits not expand employment. This partly explains the delay in U.S. employment growth which is unnerving investors in the USA.
The weakness in U.S. employment growth is one of four critical issues with the capacity to derail a global recovery and cause havoc in equity markets. These are the four issues which we have been touching on in various ways in the weekly ATC email.
- The influence of technology on financial product development and trading and whether governments in the USA and elsewhere get the balance right between curtailing its impact and letting markets efficiently allocate capital.
- How governments in Europe will solve their long term funding difficulties without coordinated fiscal policies and having to borrow in foreign currencies.
- How the Chinese economy will make a transition from growth dominated by fixed capital spending to growth driven by consumers.
How long it will take U.S. companies to reach the critical point in their profit recovery cycles when a reliance on productivity gives way to more hiring or whether they shy away from taking this next step.
The 3% fall in U.S. equity markets last Friday after a disappointing employment report comes after a record breaking recovery in U.S. corporate profitability. The two charts at http://www.thebigpicture.com.au/atc/profits_employ.pdf show:
- the relationship between nonfarm employment growth and corporate after-tax profitability; and,
the relationship between changes in corporate profitability and labour productivity ( measured as nonfarm business output per hour worked).
Four tendencies are evident over the 20 years spanned by these two charts.
- Profit growth (shown in the yellow line) tends to be more volatile than employment growth but trend changes in employment growth broadly match trend changes in profit growth.
- When profit growth is weak such as in the late 1990s and again in 2008, there is more emphasis on boosting productivity. Conversely, when profit growth is sustained or high as in 1994-1995 and in 2005-2006, there is less emphasis on productivity growth and greater preparedness to employ.
- Following a 40% contraction in corporate profits over the year to December 2008, business engineered an unprecedented improvement in productivity.
The productivity rebuild in the current cycle has brought with it a 50% increase in profits from their nadir in December 2008.
The source of profitability does not necessarily matter for equity markets. As time goes by, however, companies must move from productivity based profit growth to profit that comes from a sustainable increase in demand. Higher demand will depend on higher employment and income growth which is linked back to business confidence and profitability.
Friday's severe market reaction to the numbers from the Bureau of Labor Statistics reflects anxiety about this connection being made. The extreme reaction was aggravated by the extraordinary expectations that had arisen about the May payroll data. On Wednesday, President Obama himself broke the long-established rule that politicians should never speculate about upcoming economic statistics. His explicit endorsement of some already overly bullish forecasts by market commentators cemented how the market would react if the statistics came in short.
Given the way business makes decisions, restoring employment early in a cyclical profit recovery was always going to be highly improbable. On this occasion, given the surrounding circumstances, business was likely to seek even more certainty than usual about the sustainability of its profit base before it commenced to hire again.
Patience might be tested but the usual and all important sequence of productivity based profits coming as a prelude to strengthening employment growth does seem to have been put in place. On that score, at least, we can take some comfort.
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