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The Actuary The magazine of the Institute & Faculty of Actuaries
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An analysis of unit labour costs

It is standard actuarial thinking that equities are a good match in the long run for salary-related liabilities. This is because equities are considered a good match for the ‘real’ nature of these liabilities and they are also considered a good match by term.
However, this fails to recognise that over considerable periods of time salary growth can considerably outstrip equity market growth, and vice versa.

Economic theory
In any economy there are four ‘factors of production’: land, labour, capital, and enterprise. Each of these factors earns an income: rent, salaries, interest, and profit. Hence, investing in a factor of production that generates profit is not a matching asset for a liability based on a factor of production that generates salaries. The risk with this mismatch is that over time structural changes in an economy can mean one factor of production will see its income grow much quicker than another factor of production.
So why is this important, and, more specifically, why is it important now? Quite simply, there are currently historic structural changes going on in the world economy such as the huge technological improvements that have taken place over recent years, including the Internet. As the logic outlined below shows, these have resulted in salary growth significantly outstripping profit growth, resulting in the standard matching argument being partly invalidated.
These changes have had an impact over the last few years on firms’ costs and profit margins as well as an impact on salaries.

Firms’ costs
The cost of implementing technological improvements should be compared to the marginal benefit arising from them. One might expect that these technological improvements would benefit enterprises by reducing unit labour costs (ULCs) as workers should be more efficient and/or because not as many workers would be needed to produce the same output.
However, over the last seven years, ULCs have risen in real terms. This has largely been because the price paid for these technological improvements by firms (mainly the price paid for IT expertise, especially IT consultants and staff) has been roughly equal to the marginal benefit gained. This has left firms no better off.

Firms’ profit margins
The effects of these technological improvements have been to also:
– reduce barriers to entry in most industries this can be seen, for example, in the ease of setting up an Internet company;
– improve information flows this has resulted in more abnormal profits being spotted and then being competed away.
Economists will recognise these as either the ingredients for a perfectly competitive market or, in other cases, the ingredients for a zero-profit duopoly outcome. In any event, the result of the above is profit margins being eroded in virtually all industries. Even Wallmart, the biggest bulk buyer in the world, has seen its margins being slashed.
It seems the structural changes/technological improvements have not reduced firms’ costs but have cut their profit margins. In terms of the factors of production (land, labour, capital, and enterprise), this has resulted in a transfer of income from enterprise (lower profits) to labour (through higher wages and cheaper prices): labour is getting a bigger slice of the economic growth that has resulted from these technological improvements.
Data for the US economy shown in the graphs provides empirical evidence of such a transfer of income. This explains the so-called US recession last year. The enterprise side of the economy was having a bad time, which people extrapolated to call a recession. But when the GDP figures came out they showed no recession. The consumer (labour) was still having good times; the cake was just divided up differently!
The structural changes have resulted in an outcome that has caused salaries to grow quicker than profits. This leaves those who have tried to ‘hedge’ their salary-related liabilities with equities facing falls in their asset/liability ratios.
Current US equity market valuations show the S&P500 having a P/E ratio of approximately 40 based on current earnings. This compares to an historical average of 1214. With no likely change in the above structural conditions, the likelihood is that profit margins will remain under pressure. This does not bode well for stock prices, especially those with very high P/E ratios in very competitive markets.

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