US adds 222 thousand jobs

From the Wall Street Journal:

U.S. employers picked up their pace of hiring in June. Nonfarm payrolls rose by a seasonally adjusted 222,000 from the prior month, the Labor Department said. The unemployment rate ticked up to 4.4% from 4.3% the prior month as more people joined the workforce…..

Job Gains

Source: St Louis Fed & BLS

Forecast GDP for the current quarter — total payrolls * hours worked — is rising, showing an improving economy.

Real GDP Forecast

Source: St Louis Fed, BLS & BEA

Declining corporate profits as a percentage of net value added (RHS) is typical of mid-cycle growth, while employee compensation (% of net value added) is rising at a modest pace. Peaks in employee compensation are normally accompanied by troughs in corporate profits…..and followed by a recession.

US Corporate Profits and Employee Compensation as percentage of Value Added

Source: St Louis Fed & BEA

Average wage rate growth, both for production/non-supervisory and all employees, remains below 2.5% per year. Absence of wage rate pressure suggests that the Fed will be in no hurry to hike interest rates to curb inflationary pressure.

Hourly Wage Rate Growth

Source: St Louis Fed & BLS

Which should mean further growth ahead.

A bump for Donald Trump next year

From Tim Wallace at The Age:

Nine years on from the start of the financial crisis, the US recovery may be overheating, Legal & General Investment Management economist James Carrick has warned.

He has predicted a series of interest rate hikes will tip the US into a 2018 recession.”Every recession in the US has been caused by a tightening of credit conditions,” he said, noting inflation is on the rise and the US Federal Reserve is discussing plans for higher interest rates.

Officials at the Fed have only raised interest rates cautiously, because inflation has not taken off, so they do not believe the Fed needs to take the heat out of the economy.

But economists fear the strong dollar and low global commodity prices have restricted inflation and disguised domestic price rises. Underneath this, they fear the economy is already overheating.

As a result, they expect inflation to pick up sharply this year, forcing more rapid interest rate hikes.

That could cause a recession next year, they say. In their models, the signals are that this could take place in mid-2018.

I agree that most recessions are caused by tighter monetary policy from the Fed but the mid-2018 timing will depend on hourly earnings rates.

Hourly earnings are a good indicator of underlying inflationary pressure and a sharp rise is likely to attract a response from the Fed. The chart below shows how the Fed slams on the brakes whenever average hourly earning rates grow above 3.0 percent. Each surge in hourly earnings is matched by a dip in the currency growth rate as the Fed tightens the supply of money to slow the economy and reduce inflationary pressure.

Hourly Earnings Growth compared to Currency in Circulation

Two anomalies on the above chart warrant explanation. First, is the sharp upward spike in currency growth in 1999/2000 when the Fed reacted to the LTCM crisis with monetary stimulus despite high inflationary pressures. Second, is the sharp dip in 2010 when the Fed took its foot off the gas pedal too soon after the financial crisis of 2008/2009, mistaking it for a regular recession.

Hourly earnings growth has risen to 2.5 percent but the Fed is only likely to react with tighter monetary policy when earnings growth reaches 3.0 percent. Recent rate rises are more about normalizing interest rates and are no cause for alarm.

I am more concerned about the impact that rising employment costs will have on corporate earnings.

The chart below is one of my favorites and shows the relationship between employee compensation and corporate profits (after tax) as a percentage of net value added. Profit margins rise when employment costs fall, and fall when employment costs rise.

Profits After Tax v. Employment Costs as a Percentage of Value Added

Employee compensation is clearly rising and corporate profits falling as a percentage of net value added. If this trend continues in 2017 (last available data is Q3 2016) then corporate earnings are likely to come under pressure and stock prices fall.

Source: Warning of bump for Donald Trump next year with slide into recession

Wages and corporate profits

Employee Compensation as a percentage of Net Value Added (by US Corporate Business) has fallen sharply since the GFC, boosting corporate profits. Again we can observe an inverse relationship, with corporate profits spiking when compensation rates fall, and vice versa.

Employee Compensation compared to Net Value Added

A sharp fall in unemployment would send wage rates soaring, as employers bid for scarce labor. But that is not yet on the horizon and we are likely to experience soft wage rates until the economy recovers.

What is contributing to the surge in US corporate profits?

Some concern has been expressed in the media about the rising level of margin debt in the US. When expressed as a percentage of GDP, NYSE margin debt is approaching 1999/2007 levels.

NYSE Margin Debt as percentage of GDP

But not only margin debt is rising. Market capitalization, while not as fast, is also on the increase.

NYSE Market Cap as percentage of GDP

And market cap merely reflects the underlying rise in corporate profits, measured here as a percentage of GDP.

Corporate Profits as percentage of GDP

My initial reaction was to attribute the rise to increasing globalization of US corporations, but Rebecca Wilder points out that earnings from abroad have scarcely grown. Closer scrutiny of the Bureau of Economic Analysis Q1 2013 release shows Manufacturing is the top growth sector.

So what is contributing to the surge in corporate profits?

Employee compensation has declined as a percentage of net value added by the corporate sector over the last decade.

Corporate Profits as percentage of GDP

And there has been a sharp rise in petroleum and coal output, reflected by producers’ annual value shipped ($billion) in the graph below.

Petroleum and Coal shipments

Also, the percentage of corporate profits paid as taxes is shrinking. The following graph compares corporate profits after tax to corporate profits before tax. Less than 20 percent of corporate profits is currently being paid in taxes.

Corporate Profits as percentage of GDP

Are these ratios sustainable?

While unemployment remains high, growth in employee compensation is expected to be low. And corporate taxes are likely to remain low until there is a major overhaul of the tax code (don’t hold your breath). So market capitalization is likely to remain strong for at least the next two to three years.


Australian margin debt is declining steeply as a percentage of GDP.

ASX Margin Debt to GDP

ASX market capitalisation as a percentage of GDP is also trending lower. The 2009/2012 lows should provide a sound base for further gains.

ASX Market Cap to GDP

The ASX is muted compared to US markets, but offers value in the long-term.