Compensation of Employees

Further deceleration in the Australian credit impulse – Feb 2017

The latest RBA credit and lending aggregates for Feb 2017 show that the growth in new credit has continued to decelerate.

Total Private Credit – growth in new credit decelerates further in Feb to -$24b

The growth in new credit at the aggregate level (total private sector) began to decelerate sharply from April 2016. Since then, the annual growth in new credit has gone from +$30b in April 2016 to -$24b as of the latest February 2017 data. This is now approaching the lows reached in mid-2013:-

Source: RBA, The Macroeconomic Project

The main driver of this slowing growth in new credit has been business credit, which has continued to slow since June 2016. The growth in new credit for mortgages started to accelerate in November 2016, but this has not been large enough to offset the deceleration in business credit growth.

Progressively smaller increments in the growth in new credit are likely to result in lower spending and growth. Consider that the annual growth in the stock of total private credit in February 2016 was $161.9b and this annual growth in credit slowed to $137.9b in February 2017 – overall, this is -$24b less annual credit growth in the economy. This equates to approx. -1.4% of nominal GDP.

Given the recent strength in economic growth data (which is so far only the Dec ’16 quarter), the question is whether other sources of spending growth, such as income, are accelerating to offset this deceleration in total private credit growth.

Read more on the Australian Debt and Credit Impulse page of this blog.

Transitioning well? Australian GDP & National Income – Dec 2015

At first glance, the data relating to the 4th quarter GDP was fairly straightforward. The Australian economy grew by +0.6% in the final quarter of 2015, better than the +0.4% growth expected, but well down on the previous quarter. The upward revision to the previous September quarter growth from +0.94% to +1.09% growth resulted in annual GDP growth upgraded to +2.96%. This bumped up annual GDP growth to just above average trend growth for the last 10 years. This got quite a few people excited and soon many had jumped back onto the bandwagon that the economy is transitioning well out of the mining boom. It’s always worth looking deeper into the drivers of growth and this quarter is no exception. Whilst this isn’t a bad result at all, there is still enough in the data to challenge the narrative that Australia is transitioning well.

December 2015 quarterly real GDP growth +0.63%

Despite being well down on the previous quarter, GDP growth for the December quarter was very much in line with the average for the last 10 years. This is clearly not a bad result looking at the quarterly results over the last 20 years.

Source: ABS

Of all the components that make up GDP, household consumption spending made the largest contribution to GDP growth on both an annual and quarterly basis.

Source: ABS

Household spending contributed over half of the growth for the year and two thirds of the growth for the quarter. It didn’t take long before this was labelled the ‘strength in the household sector’. I’ll come back to this point later.

Government consumption expenditure and net exports both made a strong positive contribution for the year, but barely contributed to growth in the latest quarter.

Private investment continued to go backwards for the year and the quarter, but government investment spending made a surprise and welcome positive contribution to growth in the latest quarter.

Inventories made a positive contribution in both the quarter and the year. Inventories represent work in progress, materials and finished goods etc. that are owned by the business, whether they are held at the business premises or elsewhere and are recorded at book value at the end of the quarter. It’s difficult to pinpoint what this means – either inventories were ramped up on higher demand expectations or lower than expected sales resulted in increased inventories. The higher contribution is the result of the ‘change in inventories’ going from negative in the previous quarter to positive in the latest quarter.

But real National Income keeps falling

Real GDP growth is a measure of the growth in the underlying output of the economy. But National Income is a better measure of the income derived from/generated by that output. The ABS recommends Real Net National Disposable Income (RNNDI) as the best measure of changes in our “economic wellbeing”. This measure “adjusts the volume measure of GDP for the terms of trade effect, real net incomes from overseas and consumption of fixed capital” (source: ABS). Using this measure, National Income continued its recent decline, falling another -1.1% for the year and -0.1% for the quarter. A big driver of this decline was the latest 12% fall in our terms of trade (ToT).

The real NNDI measure isn’t broken down into its component parts so that we can understand where/what part of National Income is driving this decline. There are several elements that make up the National Income figure – employee compensation, the gross operating surplus (corporate profit proxy) and gross mixed income (surplus/deficit from the operations of smaller unincorporated enterprises). In order to go to this more detailed level, I need to revert to Gross National Income (GNI) in current prices (nominal). In real terms national income is falling. But in nominal terms, gross national income is growing at +2.6%.

I’ve used the chart below before because it provides perspective on how much our National Income growth has slowed over the last five (5) years.

Each bar represents the annual growth in Gross National Income and shows how each component has contributed to growth in that year. Whilst National Income growth, and the contribution from its component parts, is not on its lows, it hasn’t accelerated higher in the latest year either (and we know that in real terms, National Income is declining).

Source: ABS 5206.11

The annual rate of growth in GNI has remained fairly stable over the last two quarters. But a different picture emerges when you look at the quarter on quarter growth rates.

The latest quarter National Income growth is slowing

The December quarter growth was in fact slower than in the previous quarter. The chart below looks at the same National Income components, but using the quarter on quarter growth for the last eight (8) quarters:-

Source: ABS

There are two important points I want to make about the December quarter results.

Firstly, there was a larger contribution from ‘Gross Operating Surplus’ (GOS) in the December quarter (orange bars in the chart above).

This needs to be broken down further because it doesn’t tell us much in aggregate. The GOS is the sum of private, public and financial corporation surplus (a profit proxy), general government surplus and the surplus generated by dwellings owned by persons. Here is how each of those components has contributed to growth over the last eight (8) quarters:

Source: ABS 5206.07 – the sum of these components represent the “GOS” component of National Income.

The contribution from General Government and Dwellings is fairly consistent. Business profitability, on the other hand, tells us something important about the trading environment.

According to the National Accounts, in the chart above, private non-financial corporations have made the largest contribution to growth only in the last two quarters (light blue bars), which is a large turnaround in performance compared to the prior six (6) quarters. This is the single largest component of the GOS and is probably the most important to look at in relation to underlying business conditions. We know that Mining has a large influence on the outcome of this measure. The ‘Mining’ industry accounts for a substantial 26% of corporate profits (Source: 5675.11) – no other industry group comes close to this.

According to the data in 5675.11 Business Indicators, the performance of Mining in the Sept quarter (versus the June quarter) was actually positive and which made a large contribution to the positive shift in corporate profits. But according to the same data source, Mining profits fell again in the December quarter. That would then mean that Non-Mining business profits would have had to have accelerated in the December quarter in order for total private non-financial corporations to continue to make a positive contribution overall (again I’m referring to the December quarter light blue bar in the chart above). This would be an important insight about the performance and transitioning of the economy. So did non-mining profits accelerate?

We can only get down to industry-level data by looking at Company Gross Operating Profits released by the ABS as a part of Business Indicators (5676.11) data release. You can also use 5676.15 – the direction of the data is the same between the two data sources. According to the ABS:

“Company gross operating profits data are used to compile estimates of gross operating surplus of private non-financial corporations” (Source: ABS Business Indicators)

The two measures of company profit aren’t identical, but are very similar. Comparing the results of the two measure over time, there are consistently differences in the rate of growth between the two measures, but rarely do they point in opposite directions/conflict. Except for this quarter.

Breaking down the result by industry in 5676.11 yields a very different result to that of the National Income figures.

At a total industry level, Company Gross Operating Profits declined by -2.8% in the December quarter versus the National Income figures which shows that the Gross Operating Surplus of Private non-financial corporations grew by +0.9%.

According to the data in 5676.11, the decline in Company Gross Operating Profits was driven by both Mining and Non-Mining industries in the latest quarter:-

Source: ABS 5676.11

The only quarter where Mining profits were positive was in the Sept 15 quarter, which is consistent with the stronger results in the Sept quarter.

Non-Mining is the big news here – corporate profit growth has deteriorated in the last two quarters, so much so that Non-Mining Company Gross Operating Profits declined in the December quarter. So if both Mining & Non-Mining profits declined in the latest quarter according to the Business Indicators data (5676.11), then how can the similar measure of “Private Non-Financial Corporations GOS” from 5206.07) make a larger positive contribution to National Income growth in the latest quarter?

From the ABS website (Business Indicators 5676 page):-


Valuation changes have had an impact on the value of inventories held by Australian businesses this quarter. An inventories valuation adjustment (IVA) is applied in the calculation of the gross operating surplus of private non-financial corporations (GOS) estimate in the Australian National Accounts. The IVA for the December quarter 2015 is -$1,369m which is $1,974m lower than the September quarter 2015 IVA of $605m.

No adjustment is made to the company gross operating profits (CGOP) estimate in this publication and, as a result, users should exercise caution when comparing CGOP and GOS (my emphasis). It should be noted that there are other differences between the two series. In particular, changes are made to GOS when annual benchmarks are applied and slightly different seasonal factors apply to the two series. Given this, while CGOP movements are an appropriate indicator for GOS, the two series will not have equivalent seasonally adjusted movements from quarter to quarter. (Source: ABS – Business Indicators Dec 2015)

So comparison between the two measures is problematic. If no adjustment has been made to the CGOP in Business Indicators, then did the application of a lower inventory valuation actually increase the GOS in the National Accounts in the latest quarter? Could differences in seasonal adjustment account for all of the difference? Which indicator is then the more accurate representation of underlying business profit performance? As mentioned, non-mining industry performance is an important indicator for how the economy is really transitioning.

At best there is a question over the real direction of profit growth at an industry level. I have put this to the ABS for clarification.

The second point relates to the slow-down in growth of Compensation of Employees.

Employee compensation is the largest proportion of National Income at 50% and provides some basic context for the scope of spending growth in the economy.

The accelerating growth in employee compensation since the December 14 quarter has been consistent with an improving labour market at the same time. Except in the latest quarter, when growth in compensation more than halved between the two quarters.

Source: ABS 5206.44

I’ve compared the growth in Sept (Sep v June) and Dec (Dec v Sep) by state (5206.44) in the chart below. Breaking the data down to state level gives some indication of performance differences between mining and non-mining states. It’s not a perfect proxy.

Only in WA and ACT did the growth in compensation of employees improve over the last two quarters. In WA, the best thing you can say is that employee compensation didn’t continue to fall.

Source: ABS 5206.44

Most of the slow down between the two quarters can be attributed to the private sector which accounted for two thirds of the slow down.

Private sector employee compensation growth slowed the most in NSW – again, the engine room of the so-called transition – from +2.5% to +1.1%. This is actually consistent with my previous labour market update highlighting that NSW labour market was no longer looking as strong as it had been.

VIC had the highest quarterly rate of employee compensation growth in December of all the states. Although growth has been slowing for two quarters now, it is still around the average:-

Source: ABS

The main problem state is QLD – the decline in private sector compensation of employees has been accelerating over the last two quarters – the first time since the GFC:-

Source: ABS 5206.44

This is unfortunately at odds with the previous labour market update, which showed employment growth in QLD still at its peak as of the end of 2015.

The situation is similar in South Australia – private sector employee compensation growth has slowed over the last three quarters and has now turned negative in the December quarter.

Growth in employee compensation in WA has been negative for the last four quarters, but in the latest quarter, it has stopped declining, which means it’s still on its lows. In TAS and NT growth in employee compensation also slowed to virtually zero in the latest qtr.

Only in ACT did the growth in compensation of employees accelerate higher in the latest quarter:-

Source: ABS

Across most of the larger states, growth in employee compensation looks like it is slowing, if not outright declining. I’m using the eastern seaboard states (especially NSW and VIC) as proxies to gauge the ‘transition’ from mining states to non-mining states. The original point was about highlighting the slowdown in employee compensation growth between the two quarters. Most of this slow down can be attributed to NSW, VIC & QLD, with NSW by far the biggest contributor to the slow down between the two quarters. It could be a one off for NSW as there is no established trend there at the moment, but this outcome is consistent with my previous labour market outlook for NSW. This puts a dent in the narrative that the economy is transitioning well.

But there is more.

This slowdown in the growth of employee compensation in the December 15 quarter came at a time when growth in hrs worked has been accelerating higher over the last 3 qtrs. The growth in hours worked in the latest quarter is the second highest since the GFC and growth accelerated from 0.4% in the September quarter to +1.17% in the December quarter.

Source: ABS

This has brought the annual rate of growth close to pre-GFC highs. Growth in hours worked has been accelerating since late 2012.

Source: ABS

Yet, output hasn’t grown along with hours worked. In fact, output per hour worked (labour productivity) has been slowing since late 2012 and has started declining.

Source: ABS

In the December quarter, labour productivity declined by -0.6% to bring the annual decline to -0.4%.

The concept of “unrequited input growth” was raised in a Productivity Commission report into falling Australian productivity (source: Productivity Commission Report, “Australia’s Productivity Growth Slump: Signs of Crisis, Adjustment or both?” April 2012):-

“And so, in proximate terms, the decline in MFP [multi factor productivity] growth was associated with ‘unrequited input growth’ — strong acceleration in input demand that was not matched (or stimulated) by an acceleration in output growth. This is the key to understanding Australia’s much poorer productivity growth. Explanations must tell us why Australian businesses used a lot more inputs, without getting more growth in output ”

This was from a paper written in April 2012, so is not referencing this current labour productivity situation. The quote goes on to say that such a situation is not sustainable:

“The notion of unrequited input acceleration does raise the question of how such a phenomenon could be sustained. Typically, output growth provides the additional income needed to fund additional growth in inputs. Consequently, unrequited input growth does not make financial sense, unless there is another source of income growth. Chapter 2 also shows that profitability not only held up, but actually increased in the 2000s. The extra input accumulation was fuelled at least in part by increased profits and profit expectations. Clearly, productivity was not the source of growth in output and income that it was in the 1990s. Rather, the broad productivity trends of the 2000s seem to have been more the outcome of strong input growth driven by marked changes in prices and profits.”

In other words, the ‘returns’ were generated by increases in, and expected increases in, prices including commodity prices, rather than higher productivity generating greater profits.

We no longer enjoy those ToT benefits. Which brings me back to the idea of sustainability of input growth (increasing hours worked) without getting more output growth as a result. The annual growth in hours worked chart suggests that in recent times, when growth in hours worked has resulted in negative labour productivity, hours worked has started to fall. We are now at that stage of the cycle where labour productivity growth has turned negative and we’ll see whether this higher growth in hours can be sustained.

So far ‘rebalancing’ or transitioning has seen higher hours worked but no discernible increase in output growth, and in fact, if you use the Business Indicators data, declining company profits across mining and non-mining in the latest quarter. In the absence of price growth, this is not likely to be sustainable.

So how can Household consumption be the main driver of economic growth?

My final point on the December GDP result and the idea of the transitioning economy, relates to our single largest driver of economic growth at the moment – households.

The big news from GDP was the strength of household expenditure and its resilience in the face of our transitioning economy.

Whilst the contribution from households is large, the direction of spending growth has remained fairly steady over the last few years – not accelerating growth. The current annual rate of growth in real household consumption expenditure is now +2.9% (+4.6% in nominal terms). On a quarterly basis, growth pulled back only slightly from +0.9% in September to +0.8% in December.

Source: ABS

Compared to recent history, growth in household spending has been growing at a fairly consistent rate of just under 3% for the last 18 months.

This rate of growth is not great when you consider that the rate of household consumption growth has been much higher in previous years. But how could household spending be any higher? The context from National Income shows that employee compensation growth (and wages) has slowed considerably over the last five years and in some states, employee compensation has recently turned negative. This has translated into slowing growth in household gross disposable income as well.

Gross disposable household income growth has been slowing since it peaked in 2007 at +12% annual growth – growth is now running at +3.1%. Adjusted for CPI, gross disposable household income is only growing at 1.4% in real terms. This rate of growth is low and is slowing:-

Source: ABS

Maybe the real question is how household consumption expenditure growth has remained at this constant level while household income growth has been slowing?

One reason is due to falling net household saving. Note that the ‘net savings’ measure is actually a calculation of the difference between income and spending of households. As spending increases faster than income, net saving falls. This is what has been happening since the peak in net household saving since mid-2012. In the last year, net household saving has fallen 15%.

Source: ABS

This fall in net saving is partly funding the growth in household consumption.

The other important source funding household spending growth is household debt. While growth in household disposable income has been slowing and is now at a relatively low point, real mortgage debt as a % of real GDP has been rising to its highest point – accelerating in fact since mid-2014. The stock of outstanding housing debt now represents 85.5% of real GDP (total real private debt represents 140% of real GDP):-

Source: ABS, RBA

Compared to household disposable income, household debt now represents in excess of 175% of disposable income.

It seems we might be pinning our hopes on a transition based on continued spending by households that have been facing lower income growth and greater levels of indebtedness. Whilst the GDP top-line results look good, the underlying factors say that the success of the ‘transition’ is on shaky ground.

They say we’re in an ‘income recession’…

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.

Source: ABS

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.

Source: ABS

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:-

Source: ABS

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.