How companies have juiced their lemons

It’s not just the potential actions of the Federal Reserve that should worry investors, according to former Goldman Sachs economist Gavyn Davies, writing in the Financial Times. “The fundamental earning capacity of corporate America” is about to be “found wanting”.

Take a look at the annual contribution that company profits make to GDP (broadly, a measure of national wealth) over the last century and you will find that it fluctuates around a pretty constant average. However, in recent years corporate profits as a share of GDP have risen sharply “above previous peaks”. Why? Because at the same time the share of GDP accounted for by wages has been falling to “unprecedented depths”.

According to the International Labour Organisation, a UN agency, the share of GDP in the advanced economies accounted for by gross profit has risen by about 10% of GDP over the past 30 years. The wage share has fallen by about the same amount. So shareholders have enjoyed a windfall as firms have grown output per head while shrinking ‘real’ (after-inflation) wages. Put bluntly, firms have squeezed more juice from their lemons than ever before.

How much more? Davies estimates that if that 10% drop in the wage share of GDP had not occurred, and everything else had stayed the same, then net corporate profits would be up to two-thirds lower than they are today. The reasons behind this shift are complex – technology, globalisation and a reduction in labour bargaining power have all played their part.

But one thing’s for sure: should this decline in wages reverse – and most trends “mean revert” eventually – equity markets could be very vulnerable indeed.