Peak employment could be the start of bad news

Let’s hope corporate America has enjoyed its run. Now it’s workers’ turn.

Earnings reports show that profits soared in the first quarter from a year earlier. Yet last week’s strong jobs report should temper expectations that profits can continue to grow robustly, or even at all. This may well be the high point in this cycle for corporate America’s profitability.

Profits tend to peak well in advance of stock market peaks and the start of recessions. In the last two business cycles, the stock market peaked in the first quarter of 2000 and the fourth quarter of 2007. Yet corporate profits, as reported by the US Bureau of Economic Analysis, peaked in the fourth quarter of 1997 and the third quarter of 2006.

Even in this cycle, as of the fourth quarter of 2016, corporate profits have not grown at all since the first quarter of 2012, a reality masked by a large rally in the stock market.

How can this be? Why would the stock market continue to increase for months or several quarters after corporate profits have peaked? One possibility is the “Amazon scenario”.

Amazon has been famous since its inception for reinvesting its profits in the continued growth of its business. As recently as 2014 it lost money. But this doesn’t mean Amazon was struggling.

Instead, it had so many promising investment opportunities that it chose to deploy its capital making those investments rather than banking profits. This scenario can occur for the economy as a whole late in an economic cycle, as a tight labour market leads to strong wage growth, which leads consumers to spend more money, which leads companies to make investments to meet this growth in consumer demand.

It might mean lower profits but doesn’t necessarily mean reduced long-term profitability.

Another explanation for a divergence between corporate profits and the stock market is that not all businesses in America are represented in stock indices. The corner dry cleaners aren’t a member of the S&P 500.

Should wage pressure and rising interest rates pressure profit margins for businesses, the large and diversified companies like those on stock exchanges may be better suited to manage those pressures than smaller private businesses with less access to capital.

Still another discrepancy between corporate profits and the stock market is that large multinational companies, especially those in technology and healthcare, earn a significant portion of their profits from their overseas operations. Profit stagnation in the US doesn’t necessarily mean that profits are falling from sales to China.

And of course, even if profits are stagnating, nothing prevents “animal spirits” from lifting stocks higher. Businesses are the beneficiaries in the early part of a business cycle as economic growth returns while the job market is still sluggish, with additional revenue flowing to companies’ bottom-lines rather than workers’ paychecks.

But the relationship flips later in the cycle. There are a lot more workers than business owners in America, and if workers are feeling flush, their spending can lift overall economic optimism, leading to a stock market rally even if business profitability is deteriorating.

Those caveats aside, a peak in corporate profits brought about by full employment represents the beginning of the end of a business cycle. Starting from full employment, the longer a business cycle continues the more it’s workers, rather than companies, who benefit from economic growth.

Accelerating wage growth leads to higher inflation, putting pressure on the Federal Reserve to increase interest rates faster. Tightening credit conditions eventually slow down economic activity.

For most workers, full employment means that the good times are just beginning. Well. Not so much for those few workers in the corner office. Their good times are ending.