The primary (and perhaps sole) justification for carrying the levels of risk shown above relates to corporate profits. As shown below, profit margins have reached levels not seen in decades. The challenge, which we have discussed many times before: what is driving these margins ? One useful way to deconstruct profits is to measure them from peak to peak, and analyze what changed. As shown in the first chart, S&P 500 profit margins increased by ~1.3% from 2000 to 2007. There are a lot of moving parts in the margin equation, but as shown in the second chart, reductions in wages and benefits explain the majority of the net improvement in margins. This trend has continued; as we have shown several times over the last two years, US labor compensation is now at a 50-year low relative to both company sales and US GDP (see EoTM April 26, 2011).
Last week’s train wreck of a labor report included the dour news that labor compensation is now firmly negative in real terms. Why is US labor compensation so low? The lingering excess labor supply from the recession is one reason, but the 2 billion people in Asia joining the global labor force over the last two decades is another. As shown on next page, EM wages for production workers remain well below US levels. Another factor helping profit margins: increased US imports of intermediate goods from Asia. As shown in the accompanying chart, imports from Asia have been rising, and over the same time frame, Asian import prices only increased at around 1% per year. (...)