“Corporate profits were strong in 2013, with S&P 500 profits jumping an estimated 11% year-over-year.
With profit margins at record highs, some fear that we are due for some mean reversion, which could mean falling profits and tumbling stock prices.
However, Goldman Sachs’ Jan Hatzius doesn’t believe 2014 will see profits pull back.
“Profits are likely to accelerate in 2014, as GDP and productivity growth recover but wage growth picks up only gradually,” wrote Hatzius in a new note to clients. “Eventually, the pendulum will swing back in the direction of lower profits, but probably not until the labor market has recovered sufficiently to push up hourly wage growth up to 4% or more.”
Let’s unpack this.
To understand his bullish thesis, you have to look back at 2013, a year when profit growth overcame significant headwinds. Hatzius identified three: 1) relatively weak GDP and productivity growth in the U.S.; 2) very weak growth outside of the U.S.; and 3) low and declining inflation.
Despite these challenges, after-tax corporate profits grew an estimated 6.5% using the definition of the national income and product accounts (NIPA).
Goldman Sachs
Here’s Hatzius on the strength:
What accounts for the strength? We believe that the key reason is the continued slack in the US labor market, and the resulting weakness of nominal wage growth. Exhibit 1 shows that our wage tracker–a composite measure based on the three most widely used hourly wage measures–is still only growing at about 2%. This weakness has held down unit labor costs even in an environment of sluggish GDP and productivity growth. And in turn, the subdued growth of unit labor costs has supported profit margins even in an environment of low price inflation…
For 2014, Hatzius expects wage growth to remain modest. Furthermore, he expects the three headwinds mentioned earlier to act as tailwinds…”
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