These are important questions at two levels. There is an obvious significance for financial markets in company profitability, as the present high price/earnings ratios can only be justified by a sustained increase in profits and dividends. But there is a wider significance for the living standards in the developed world. The only way countries can justify paying people wages 10 or more times the levels of those in the new industrial nations like China, is if we can manage to restructure our companies so that they add sufficient value to their products and services to justify our labour costs.
In other words, they have to be able to increase profits despite the challenge from low-cost nations.
The equity strategy team at Goldman Sachs have had a crack at trying to answer these questions in their latest paper. Their approach is to try to isolate the boost to profits that companies in the US, Japan, Germany, France and the UK have achieved by restructuring, rather than the boost expected for purely cyclical reasons. It is a fairly simple mathematical exercise, but the issue is so important it deserves a wider airing.
Goldman estimates that in the US the restructuring bonus - the gain in earnings not explained by the rise in general demand - is equivalent to 3.3 per cent of profits. In the UK it is 2.1 per cent and in France 1.5 per cent. In Germany and Japan, however, there is no bonus: there is a negative 0.5 per cent impact on profits in Germany and a negative 1.1 per cent in Japan. In other words, companies there are less profitable than they 'ought', given the position in the economic cycle.
What should one read into this? One explanation that would square with the anecdotal evidence from companies, and which would intuitively make sense, is that the US, UK and France are further down the restructuring path than Germany or Japan. The discipline of the financial markets that forced the US and UK in particular to restructure early has given these countries greater potential to boost profits as demand recovers.
What of Japan and Germany? The analysis tries to adjust for the position of the countries in the economic cycle, but naturally the fact that the economic downturn struck the US and UK earlier has meant that these two countries ought to be further along the path. Great attention is being paid to the way German industry in particular is reorganising itself, and in the past Japanese industry has proved adept at combating its high-cost environment. But Goldman argues we may not see the benefits of German restructuring until 1995.
There are market implications in this. Looking at the next few months, companies in the US, UK and France may be able to produce better than expected profits. As demand picks up there should be an additional gearing effect: if a company can make good money when it is running at 75 per cent capacity, it ought to be very profitable at 85 per cent capacity. If this argument is right, it would justify to some extent the high rating of US (and to a lesser extent UK) equities at this stage of the cycle.
The wider conclusion would be that there are ways in which companies in mature developed countries can adapt to compete. By 'downsizing', 'rightsizing' or whatever euphemism one chooses, the corporate sector can continue to be profitable. In a way this is encouraging; the reverse would be really worrying. But such a conclusion says nothing about the ways in which the displaced labour will find new jobs. The US economy has been successful in creating jobs, though it has done so more slowly than in previous recoveries. The UK, too, is creating new jobs at an earlier stage in this economic cycle than it has in past ones.
But in both countries the new jobs are different in that they tend to offer less security, may offer lower wages, and are frequently part-time. There is little alternative for companies faced with the challenge from low-wage economies but to respond in the way they have, and arguably getting restructuring over early will be less painful than delaying the process. But the Goldman analysis only paints half the picture: even if companies do the 'right' thing, costs have to be carried elsewhere.
That is not a criticism. The really useful aspect of this work should be to focus minds on the whole restructuring process. The downsizing of industry is the more obvious feature of economic reconstruction. The more interesting side is the new way in which sophisticated economies are employing people: how they are absorbing labour displaced by newly industrialised countries. That is where the debate should now go.Reuse content