INVESTMENT | FOCUS |
An analysis of unit labour costs
Colm Fitzgerald looks at equities as a matching asset for long-term salary-related liabilities.
I
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.
T IS STANDARD ACTUARIAL THINKING
s
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: s 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 indusFigure 1 Unit labour costs tries. Even Wallmart, the biggest bulk buyer 68% ULCs 67% in the world, has seen 66% its margins being 65% slashed. 64% 63% It seems the structural changes/technological improvements Time have not reduced firms’ costs but have Data taken from: cut their profit margins. In terms of the factors of prowww.bea.doc.gov/bea/dn duction (land, labour, capital, and enterprise), this has /nipaweb/TableViewFixed resulted in a transfer of income from enterprise (lower .asp, Table 7.15) profits) to labour (through higher wages Figure 2 Profit per unit of GDP and cheaper prices): labour is getting a big14% Profits ger slice of the eco12% nomic growth that has 10% resulted from these 8% 6% technological improvements. Data for the US econTime omy 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 12–14. With no likely change in the above structural conditions, the likelihood is that profit margins will remain under pressure. This does not bode Colm Fitzgerald is an well for stock prices, especially those with very high investment consultant at Watson Wyatt ❏ P/E ratios in very competitive markets.
% of GDP
Sep 97 Sep 98 Sep 99 Sep 00 Mar 97 Mar 98 Mar 99 Mar 00 Mar 01 Sep 01
% of GDP
Mar 97
Sep 97
Mar 98
Sep 98
Mar 99
Sep 99
Mar 00
Sep 00
Mar 01
Sep 01
December 2002 | TheActuary | 29
Mar 02
Mar 02