The mess at Enron Corp. (ENRNQ
) has forced investors to put the profits outlook under the microscope. Shareholders are worried that the disease of shady accounting may have infected their own portfolios. As of Feb. 6, the Dow Jones industrial average was down some 550 points from early January, and the broader indexes are off 7% or more.
The profit outlook, however, may not be as bad as the huge sell-off on Wall Street would indicate. After all, the Milquetoast of postwar recessions is showing every sign of yielding to recovery. The latest data show that the labor markets are at least stabilizing, as is the long-beleaguered manufacturing sector, and consumers are still hanging in there.
But rising output doesn't necessarily lead to fatter bottom lines--especially not in today's economy, where pricing power is nil. Companies need to produce their goods and services in the most cost-effective way possible in order to lift their profit margins. What Enron-obsessed investors are missing is that the most important key to the earnings outlook in 2002 will be productivity. And right now, productivity is on track to post some very impressive gains this year.
THOSE ADVANCES WILL BUILD on productivity's phenomenal performance in this recession (chart). Measured as output per hour worked at nonfarm businesses, productivity in the fourth quarter of last year surged at an annual rate of 3.5% from the third quarter, bringing its annualized growth rate during the past three quarters to 2.3%. For a recession, that's startling, especially since the average showing during all recessions of the past 50 years has been -0.6%. The 2001 recession was the first in postwar history in which productivity grew in every quarter of the downturn.
Last quarter's productivity surge more than offset the 2.3% quarterly rise in compensation. Note that this measure of compensation, which includes stock options, has slowed sharply in the past year from a peak rate of 8.9% a year ago, most likely reflecting the dropoff in realized capital gains from such options.
As a result, unit labor costs--the compensation required to produce one unit of output--dropped 1.1% last quarter, the first quarterly decline in two years. That implies profit margins, as accounted by the Commerce Dept., stabilized last quarter. The growth in unit costs slowed in every quarter of 2001. In a business climate devoid of pricing power, that means companies have acted aggressively to stem the slide in their profit margins. For this year, the combination of strong productivity growth and further slowing in compensation will continue to lift margins out of their six-quarter slump.
In fact, 2002 will mark a swing in the pendulum away from household incomes and toward corporate profits. Companies will use the increased flexibility of labor markets to their advantage. That edge is evident in the ongoing shrinkage of variable pay and bonuses, along with the layoffs in temps and other contingent workers. These trends are the opposite of the late 1990s' experience when a surging economy tightened job markets. That boosted workers' pay above even the solid gains in productivity. Consequently, costs rose, and profits were squeezed.
But this year productivity gains may well outpace the increases in compensation, resulting in a further decline in unit costs. That's not only due to the variable-pay factor but also because productivity always accelerates in the early stages of a recovery. Businesses are slow to rehire workers when demand first turns around. Instead, they extract more output from existing employees and lengthen work hours to fill orders. That effect will probably be greater in this recovery as businesses try to keep costs down in order to boost profits.
BUT WHILE JOB GROWTH won't come roaring back anytime soon, the January employment report offered some signs that the worst is over in the labor markets. Private-sector payrolls fell by 84,000, the smallest decline since May. Also, the Labor Dept.'s index of the breadth of job gains rose to 50.1%, the highest since March (chart). That reading means that as many companies added to their payrolls as cut them, suggesting a broad firming in labor-market conditions.
Once again, manufacturing accounted for all of last month's job losses, shedding 89,000 workers. Still, the factory sector is on the mend. Overtime hours rose for the second month in a row, and the purchasing managers' index from the Institute for Supply Management increased to 49.9% in January, the highest reading in 1 1/2 years. That reading is effectively on the 50% mark, which means activity in manufacturing is neither rising nor falling. And rising factory orders continue to show signs of future strength.
But one apparent sign of labor-market improvement--the January drop in the unemployment rate to 5.6%, from 5.8% in December--is misleading. It mainly reflects the vagaries of Labor's seasonal-adjustment process, which caused one of the largest monthly declines in the workforce on record. Many businesses, especially retailers, did not add as many workers in December as they usually do, and so they didn't have as many to lay off in January.
For example, the jobless rate in retail and wholesale trade plunged from 7.1% to 6.3%, and the rate for part-time workers fell from 5.6% to 5.2%. Look for the direction to reverse in February and for the unemployment rate to jump back up.
THE JOBLESS RATE is likely to climb higher this year as cost controls limit job growth. They are already affecting wage gains. Yearly growth in hourly pay of production workers has slowed from a peak of 4.4% last September to 4% in January. Labor's broader employment cost index, which covers all workers and includes both wages and benefits but not stock options, has slowed similarly, to 4.1% in the fourth quarter.
The big plus for households, though, is that real wages last year, even after removing the plus from cheaper energy, rose at the second-fastest pace since the 1960s. The fastest showing was in 2000 (chart). Credit productivity gains for this rise in household purchasing power even though nominal pay growth is slowing. Companies can lift compensation in line with strong productivity growth without putting pressure on unit costs. And inflation is low and may even drift lower. That's why real pay growth will undoubtedly post another good increase this year.
To be sure, consumers have neither the financial power nor pent-up demand to lead the recovery with the vigor of past upturns. But the point here is that a pickup in productivity growth is about as close to a free lunch in economics as you can get. Both wages and profits can grow this year without pushing up inflation. And Corporate America's return to profitability need not come solely on the backs of the U.S. workforce.
By James C. Cooper & Kathleen Madigan
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