U.S.: Earnings Growth Is Caught In A Vise
The U.S. economy is often compared to an ocean liner--a forward-moving behemoth that's hard to turn around. But a better analogy is an armada, with each sector making its way each year through calm seas or treacherous shoals. On average, the U.S. flotilla is moving faster than economists expected. But there is a widening gap between the speediest ships and the slowest, along with other growing imbalances that are likely to slow the economy at some point in 1999.
For now, consumers are leading the fleet. The latest employment report shows that the traditional engines of consumer spending--jobs and incomes--are going at full steam. Indeed, if the labor trends of the past six months hold, the jobless rate could easily fall below 4% by the end of summer (chart). In addition, the consumer cruiser of the 1990s has been retrofitted with an engine fueled by the stock market. Equity gains are financing an increased proportion of spending growth.
Elsewhere, though, the waters are not as smooth. In particular, profits are stagnant. That means that capital spending, while still mobile now, is losing a prime propellant: internally generated funds. And manufacturing and foreign trade have had to contend with the nor'easter of global financial turmoil. The good news is that manufacturing may be stabilizing. The bad news: Trade may not be.
WITH GROWTH TILTING toward consumers, several worrisome imbalances are building, raising new questions about the 1999 outlook. First of all, the pace of consumer spending is far out of line with income growth because of consumers' growing reliance on stock market gains. That brings potential volatility to the economy's most supportive sector. Second, a worsening current-account deficit threatens to weaken the dollar and end the benefits of cheaper imports, including low inflation and greater consumer buying power.
And most important, prices are trailing unit labor costs, which means that profits have all but stopped growing, despite a jump in fourth-quarter productivity and surging economic growth. Weak earnings hamper more than capital spending. They could also fall back on consumers as businesses try to cut their labor costs, or as a leveling off--or an outright drop--in stock prices cuts into the wealth effect on household spending.
For now, households are getting plenty of support from the labor markets, but the flip side of ever-tightening job markets is continued heavy cost pressure on businesses at a time when price hikes are difficult to pass on. The January employment report showed that job markets began 1999 on solid footing. Nonfarm payrolls mushroomed by an unexpected 245,000, and the unemployment rate remained at a 28-year low of 4.3%.
Private-service companies hired 216,000 new workers in January. The January gain in service jobs was slightly stronger than the 209,000 averaged per month in the fourth quarter, and it suggests that the service sector remains strong.
Manufacturing, though, continued to lay off workers. But at least the 13,000 drop in January was the smallest number of pink slips since September. And new factory orders jumped 2.3% in December, to a record $343.5 billion. Rising demand and fewer layoffs suggest that factory weakness has bottomed out.
Even so, manufacturing payrolls must climb out of a deep hole. Since March, factory jobs have fallen by 285,000. Smokestack America has been paring workers, partly because of falling exports and rising import competition. Steelmakers have laid off 10,000 in the past year, while textile and apparel mills have sacked 110,000. But even makers of high-tech gear are battling a glut of capacity worldwide. Over the past year, manufacturers of computers and electronic components have cut payrolls by 52,000.
IF MANUFACTURING IS RECOVERING, then the scramble to find workers will heat up. That's especially true since businesses will find fewer people available to work. An unprecedented 64.5% of Americans already hold jobs, and the ratio of the adult population in the labor force jumped in January, to a record 67.4% (chart).
History suggests that with labor markets so tight, businesses will have to offer more generous pay packages to attract skilled workers. Surprisingly, though, today's extremely tight labor market has not yet translated to the kind of wage acceleration that might touch off inflation worries. In January, hourly pay for production workers increased 0.5%, to $13.04, and for the year, nonfarm wages were up 4%. That's a shade faster than the 3.8% yearly pace of the fourth quarter, but it's still below the 4.4% rise of last April.
Why aren't wages growing even faster? For one thing, companies are finding creative ways of holding down basic wage rates, such as reclassifying production workers as salaried employees or the increased use of one-time bonuses and other forms of variable pay. Also, businesses continue to invest in capital rather than labor in the effort to boost productivity.
THAT TREND HELPED to produce a productivity bonanza in the fourth quarter as companies were able to use their existing staffs to produce more goods and services. Productivity in the nonfarm business sector grew at a sterling 3.7% annual rate from the third quarter, the largest quarterly increase in nearly three years. However, that big gain partly reflected the exaggerated advance in gross domestic product caused by the end of the strike at General Motors Corp., unseasonably mild weather, and a surge in aircraft exports.
The problem for many companies is that profits are making little, if any, headway, despite solid productivity gains, efforts to hold down labor costs, and a roaring economy. A preliminary reading of BUSINESS WEEK's survey of 900 companies shows that earnings fell last quarter from a year ago.
The latest productivity report shows why. Last year, unit labor costs rose 2%--not bad given that a strong 2.2% gain in productivity offset much of the 4.2% jump in wages and benefits. However, businesses were able to raise prices by only 0.7% (chart). By definition, that means profit margins are shrinking. Despite excellent productivity growth last year, the lack of pricing power opened up the largest deficit between price increases and the growth in unit labor costs in 11 years.
For 1999, corporate earnings growth will not improve unless that gap closes. That could happen in only two ways, both of which would be a negative for the economic outlook. First, prices could accelerate--but the Federal Reserve would thwart that with higher interest rates. Second, businesses could cut costs--but that would hurt jobs, incomes, and consumers. And either way, the stock market would be unhappy as well. So don't be surprised if sagging profits turn out to be the headwind that alters the U.S. armada's course this year.