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Goldman Sachs: Get Ready for Labor to Crush Capital in the U.S.

A shift in the balance of power.

Lofty corporate profit margins—and their seeming reluctance to return to longer-term averages—last month had Goldman Sachs Group Inc. thinking about questioning the efficacy of capitalism.

But fresh analysis from Goldman's Elad Pashtan's is sure to instill renewed faith in the Invisible Hand for any colleagues that had begun to have creeping doubts. Corporate profitability is, in fact, poised to fall, he has warned clients.

Better yet (at least for the average worker), Pashtan asserted that this decline in profit margins will be driven by employee gains at the expense of Corporate America.

"We may be on the cusp of a more broad-based margin squeeze," he wrote. "Our model of National Income and Product Accounts suggests a moderate decline in 2016-2017 as stronger wage growth is likely to redistribute income away from capital owners and back toward labor."

Profit margins have edged down in recent years, driven primarily by lower oil prices and the rise in the U.S. dollar, which weighed on revenues multinationals generated abroad. Ex-energy, the profit margin for S&P 500-stock index companies is down only a tick since the third quarter of 2014, he noted. Lower energy prices are a boon to many industries in which oil is an input cost, but this appears to have been offset by the adverse effect the greenback's gains have had on top-line performance.

Still, human capital dwarfs energy inputs as a share of gross output, Pashtan observed, and real wage growth is expected to be positive over the next few years because of the lack of slack in the labor market.

"The interdependency of compensation and output suggests a close link between wages and profit margins," he found. "Indeed, as wages accelerate above core inflation—a proxy for output prices—profit margins have correspondingly declined (assuming no changes in labor productivity)."

Goldman Sachs

"We expect this gap between prices and unit labor costs to continue to be a key driver of domestic U.S. corporate profitability," he predicted.

Goldman expects corporate after-tax profits to fall to 8.2 percent of gross national product in 2017, down from an estimated 8.5 percent in 2015, primarily attributable to the tightening labor market.

The unsettling part of Main Street > Wall Street, however, is that it typically heralds (and in fact, is the impetus of) an economic downturn.

"As the business cycle progresses and the labor market tightens, workers gain more bargaining power and demand higher wages. Firms—eager to protect their profit margins—raise prices, increasing inflationary pressure," Pashtan explained. "As inflation rises, the Fed reacts by hiking interest rates, dampening price pressures but also sending the economy into recession."

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