Good news for workers could mean trouble for investors.

The U.S. labor market is close to recovering from the financial crisis. The share of Americans ages 35 to 44 with a job is now at its highest level since the summer of 2008. This is starting to affect worker pay: While employee compensation growth stagnated after the downturn, it began meaningful acceleration in 2014 and is now closer to the pre-crisis norm than the 2010-14 average.

U.S. businesses tend to pay workers about 71% of the net value they produce, so rising wages will have a big impact on costs. Shareholders and creditors will be the ones who ultimately absorb those costs.

The traditional fear is that companies will respond by passing on wage increases to customers through higher prices. Inflation would then accelerate, interest rates would spike, and the economy would fall into a recession. This is the outcome Federal Reserve officials have expressly said they are trying to avoid with their gradual approach to raising interest rates and shrinking their balance sheet.

Gradualism, however, may be an inappropriate response to a nonlinear process. Despite past false alarms, there is a point past which companies would genuinely be unable to hire additional workers because everyone who might want a job would already have one. At that point, wage growth could accelerate far more sharply, with unpredictable effects on inflation and interest rates.


Should the Fed fail to prevent this, shareholders would get hit by the toxic combination of falling real earnings and shrinking multiples. Real total returns on U.S. stocks were deeply negative during the Great Inflation of 1966-83.

Fortunately, a repeat of the Great Inflation is not a likely consequence of the tightening jobs market. Options prices imply that sophisticated traders are unconcerned about the threat of excessive inflation. The best explanation is that economists have found little connection between the state of the job market and the inflation rate.

The Fed’s preferred measure of inflation is based on the prices of goods and services consumed by households, excluding food and energy. U.S. labor is an insignificant input for many of the most important components, such as housing and pharmaceuticals, as well as the many consumer goods imported from abroad. Health-care prices, another big chunk of the index, are determined more by government reimbursement rates than anything else. At the same time, many Americans work in export-oriented industries or for the government. Pay raises for public-school teachers or software engineers at tech companies may eventually affect consumer prices, but the links are tenuous.

The clearest way to see this is to compare the prices paid by U.S. companies against the prices paid by American consumers. The Bureau of Labor Statistics divides all industries into four stages of production, based on who produces inputs for whom. For example, grain farmers are in stage 1; cattle ranchers, stage 2; slaughterhouses, stage 3; and restaurants, stage 4. Over long stretches of time, consumer prices track the prices paid by companies at any given stage of production, but large changes in input costs within individual sectors are absorbed by profit margins before they ever reach consumers.

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The real threat to investors isn’t inflation but the possibility that workers could wind up capturing future economic growth. Since 1929, when the data begin, U.S. workers’ share of the net value created by nonfinancial corporations has ranged from less than 65% to more than 80%. Changes in this ratio have a strong inverse relationship to changes in the amount paid to creditors and shareholders. From 1970 through 2003, the workers’ share was 73%, while investors got about 12% in the form of interest payments and profits after taxes.


While this had started to change in the mid-2000s, the shift became extreme after the financial crisis: Since 2011, investors have gotten about 17% of the value produced by U.S. corporations’ domestic businesses—five percentage points above the long-term average. Investors captured a larger share of corporate output only in 1929, but corporate tax rates were far lower back then. The corollary is that the workers’ share has averaged just 68% since 2011.

This has already begun to reverse. The recent acceleration in pay growth has sharply exceeded the growth rate in the value of what workers produce. The result is that labor’s share has increased by about two percentage points since 2014. Over the same period, the investor share has dropped more than one percentage point. Exclude the impact of the corporate tax cuts passed at the end of last year, and the shift from capital to labor would have been almost one-for-one.

Further shifts in the distribution will probably hurt investors in absolute terms. While the aggregate level of profits is determined by savings and investment decisions, changes in the income generated by the U.S. nonfinancial corporate sector for creditors and shareholders together are tightly related to the shifting balance between capital and labor.

Historically, each percentage-point shift in the investor share has corresponded with a 13% change in the amount received as interest and after-tax profits. If the workers’ share rises all the way up to its 1970-2003 average, investors could collectively face losses of 50% compared with what they might otherwise have earned.


The good news for shareholders and creditors is that the data do not yet indicate this is likely: Wage growth has stalled since the end of last year, and employment rates remain far below levels reached in the late 1990s. The latest jobs report, released on Friday, confirms the trend. But further tightening of the job market could lower future returns on stocks and corporate credit.

Write to Matthew C. Klein at matthew.klein@barrons.com