That was one of the main take-outs in the mainstream press from the last round of National Accounts data released a few weeks ago now.
That soundbite is based on the National income figures – in real terms showing that National income has fallen for two consecutive quarters. It makes for a dramatic headline, but it doesn’t tell us much about the source or distribution of this fall in National income – employee compensation and/or business profits. The main source of this fall in National income can be traced back to private non-financial corporations, more specifically, to those in the mining industry. Given the fall so far in the Terms of Trade (ToT), this should be no surprise. That said, the impact is large. For the moment, the other important elements of National income, non-mining profits and compensation of employees, are both still growing, but that growth has at least halved over the last five years as the ToT has started to fall.
Will this latest fall in mining profits be absorbed by the corporate sector or will it trigger another round of falls in non-mining profits and employee compensation?
The “income recession” in charts
The ABS produces a number of National income measures. There are two important ones.
Firstly, Real Gross Domestic Income (real GDI) – “Real Gross Domestic Income (GDI) measures the purchasing power of total incomes generated by domestic production by including the impact of the ToT on GDP” (source: ABS)
Given our ToT have shifted dramatically both up and down over the last fifteen years, GDI is a better measure than GDP of the impact on our living standards.
On an annual basis, real GDI has declined at an annual rate of 0.1% and 0.2% over the last two quarters respectively.
This chart highlights just how far below trend real income growth has been in Australia since 2011. This has been triggered by falls in the prices of our major commodity exports and helps to explain why the economy is experiencing lacklustre growth.
So far, the annual fall in real GDI has been small relative to the major downturns, but growth has slowed from high levels, so the move is still a large one. There is likely to be a continued impact on National income as further falls in the ToT are expected.
The second, even better, measure of National income is Real Net National Disposable Income (real NNDI). This adjusts GDP for shifts in the ToT, nets out depreciation and takes account of net income flows to foreigners. It indicates the real net income available to Australians. On this basis, National income has fallen even faster – by -0.2% and -1.1% on an annual basis over the last two quarters respectively.
On a per capita basis, the effect is even more dramatic – real NNDI per capita has been falling on an annual basis for the last twelve (12) quarters – and that decline has accelerated over the last couple of quarters:-
The decline in real NNDI is not yet of the depth that we saw during the major downturns of the early 80’s and 90’s – but the economy isn’t technically in a recession as it was during those periods.
Breaking down National income growth – business profits and compensation of employees
The data provided by the ABS to get to this further level of detail is in current prices – which means it hasn’t been adjusted for price inflation so will differ slightly to the data above. Where necessary, I will adjust.
The bulk of our National income is 1) compensation of employees (48%) and 2) the gross operating surplus of business (31%). The “gross operating surplus” is a proxy for business profits and this 31% figure represents private non-financial corporations, public corporations, financial corporations and I’ve also included un-incorporated business in that figure, which is usually separate, called “gross mixed income”.
The two biggest areas of, and the two biggest contributors to, overall National income growth are private non-financial corporations and compensation of employees. Together they provide some insight into the performance of the economy – consumer/household spending decisions and business activity with regard to expansion or contraction of activity.
Over the last year, the gross operating surplus of private non-financial corporations was the only area that detracted from National income growth. The biggest area of National income, employee compensation, made the largest contribution to overall growth +1.07%pts.
Source: ABS 5206.07 – I have used ‘income from GDP’ in order to get the most detailed breakdown of Gross Operating Surplus and Factor Income. Total GNI and income from GDP are similar, but not quite identical.
It’s hard to know whether this is good or not without looking at how these measures have changed over time. The overall level of growth and its composition over the last 5 years tells a far more important story of the Australian economy.
In the last 2.5 years, overall growth has slowed from over 8% on average to below 2% in the latest quarter. The blue and orange bars are of special interest in the chart below:-
Source: ABS 5206.07
Growth in compensation of employees has more than halved (blue bars). Even though employee compensation is still making a positive contribution to GDP growth, growth has become significantly lower over the last 5 years. The average growth of employee compensation has slowed from 7.1% to 2.4% during the first half of the last five years versus the second half. This is also a factor behind the lower level of National income growth. Part of the reason for this slow-down in employee compensation growth over the last five (5) years may be as a result of that first fall in private non-financial corporate profits back in late 2011 (the orange bars). Despite private non-financial corporate profits improving into 2013, growth in employee compensation has remained at this low level. At the same time, there has been a higher proportion of part-time workers in the economy, much slower growth in wages across a wide range of industries, lower level of employment growth, higher unemployment and lower overall labour force participation.
The employee compensation element of National income is not in an “income recession”, but it is contributing to overall lower growth in National income. Whilst compensation of employees is currently growing at +2.2% in current prices, in real terms, it is growing much less, around +0.9% (deflated using the IPD for HFCE). So far, other sources of income are supplementing employee income in this lower growth environment – net household savings has been declining -4% on average since Sept 2012 (source: ABS 5206.20) and household debt continues to reach new highs.
So is the penny about to drop again?
Private non-financial corporate profits have been falling for the last three quarters on an annual basis (the orange bars above). The last time this happened (2012), there was a corresponding fall in compensation of employees as corporations cut costs in order to protect profits. If this is a ‘widespread’ fall in corporate profits, then there is a risk that we may see further falls in employee compensation and a further weakening of the labour market.
So far, the bigger falls in corporate profits are “limited” to mining, but there is weakness among other industries.
The gross operating surplus of private non-financial corporations – mining versus non-mining
The decline in mining profits, driven by the fall in commodity prices, is so large that it affects the aggregate picture of corporate profits in Australia. In terms of its profits, mining represents 28% of total private non-financial corporate profits. The next largest industry by this measure is manufacturing at a 10% share. That gives you a sense of the scale and likely impact of falling mining profits.
While mining profits detracted over -7% pts from growth in corporate profits, non-mining still contributed +3.4% pts to growth.
Source: ABS 5676.11
But over time, we’ve also seen the profits of the non-mining sector slow. Between Mar 2000 and Dec 2009, corporate non-mining profits grew by +12% on average. Since the peak of the ToT in 2011, non-mining profits have grown by a paltry 1.8% on average.
Source: ABS 5676.11
On a bright note, in the latest quarter, the annual rate of growth in non-mining company profits jumped to +5%. This was primarily driven by two sectors – retail and wholesale. This is mostly likely linked to the end of the financial year and “Tony’s Tradies” taxation incentives from the 2015 budget. Since June, retail sales have dropped back somewhat.
The problem is that in some of the bigger non-mining industries, profit growth is not yet accelerating – despite lower interest rates and a lower AUD.
In the chart below, company profits in the first nine (9) industries listed in the chart detracted from growth in the latest quarter. That represents a negative turnaround from a positive annual rate of profit growth in industries such as construction, transport/postal/warehousing, arts & recreation, admin services and accom & food services.
Source: ABS 5676.11
As mentioned, the second largest industry by share of company profits is manufacturing, representing 10% of profits. Company profit growth in manufacturing staged a great comeback throughout 2012/13 but that stalled throughout 2014/15 and manufacturing continues to detract from overall company profit growth. Manufacturing company profits remain 20% below where they were 5 years ago.
Construction is the third largest industry by share of company profits (8%) – growth in profits has slowed consistently over the last several years and in the latest quarter, profits fell versus the previous quarter as well as versus the same quarter a year ago.
Of the six industries that contributed profit gains, the largest was wholesale trade, which together with retail, is likely to be only a fleeting effect, given the latest retail sales data.
At best, non-mining corporate profit growth is weak. In this environment, there is a risk that compensation of employees will be impacted further and, in real terms, could start to decline.
So far, the source of the ‘income recession’ can be traced back to the fall in profits within the mining industry. If mining profits continue to fall, then there is likely to be continued spill-over effects into related and supporting industries as well as employment. At the same time, profit growth in non-mining industries is also languishing. After 3 consecutive quarters of declining company profits, corporates will be under pressure to continue to cut costs. It’s unlikely that the corporate sector will just continue to absorb these falls. The immediate risk is to the labour market and compensation of employees. So while the “income recession” has so far been driven by one sector, there is a risk that this could spread into the other areas of National income.