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Squeezed

Squeezed

What determines the distribution of income between profits and wages? For years, conventional economists - in stark contrast to their 19th century predecessors - have ducked this question. This is a shame, because it matters a lot to shareholders, and there is a danger of profits being squeezed next year.

Simple econometrics tell us that five things, taken together, have explained over half the variation in the share of non-oil profits in GDP since 1997.

One of these is unemployment. Lower unemployment, other things equal, increases workers' bargaining power and thus raises wages at the expense of profits.

A second thing is the oil price: higher oil prices hurt the profits of non-oil firms.

Thirdly, there's sterling. A weaker pound raises the profit share. This is partly because it increases exporters' margins but also because it reduces the foreign competition faced by UK firms in the domestic market, which allows them to raise mark-ups.

Fourthly, real interest rates matter: lower real interest rates squeeze profits. This might be because real interest rates are low when the economy is weak, which squeezes the profits of cyclical firms. But it’s also more directly causal: low rates keep firms in business, which intensifies competition and so depresses mark-ups.

Finally, there's household savings. Rises in these squeeze profits. There's a simple reason for this. If workers spend what they get then wages are a revenue as well as a cost which is neutral for aggregate profits - though of course not for individual firms. If, however, workers save more then wages become a net cost and so profits are squeezed.

All this brings us to a problem. These last two factors could combine to squeeze profits next year. We know that inflation will rise which will tend to reduce real interest rates. And it's possible that inflation will also cause households to save more, which will reinforce the squeeze on margins. Savings might also rise simply because they are low now, perhaps because consumers have pulled forward spending from next year into this in anticipation of future price rises.

Past relationships suggest that these two forces will offset the benefit of the slight rise in unemployment which most economists expect next year and the weak pound. This implies that aggregate UK profits might not grow at all next year even if nominal GDP rises by the 2.8 per cent which the OBR expects.

There are of course risks to this. If household savings fall, or if sterling drops or if the economy strengthens sufficiently to trigger rising interest rates then profit margins would improve. My point is, though, that there are dangers for domestically-generated profits.

You don't need to accept one person's futurology to believe this. Since the spring we've seen strong retail sales growth but a decline in the valuations on small cap stocks. These two developments are consistent with anticipations of a profit squeeze: consumers have spent in anticipation of real wage growth, while investors have been wary of the outlook for corporate earnings. The wisdom of crowds, therefore, as well as statistics, warns us of the danger of a profit squeeze.

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By Chris Dillow,
15 December 2016

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Chris Dillow

Chris spent eight years as an economist with one of Japan's largest banks. Here, he provides insightful commentary on the latest economic news and data, along with thought-provoking articles about investor behaviour.

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