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The Productivity Conundrum

Investment Strategy | October 2016

We recently polled the members of CAPTRUST’s Investment Committee to get a feel for what longer-term or structural topics they felt readers should be aware of in the coming months. What issue or issues will drive their discussions? What issues need a light shined on them? Their immediate response: productivity. They noted a meaningful gap between economists’ thoughts on this foundational topic and what is covered in the popular press.

We will explore the concept of productivity and its implications for investors, offering insight into a topic with both relevance and shelf life.

Q: The word productivity has several meanings in everyday life. What is productivity, and why do you view it as such a key issue?

A: Productivity, in the economic sense, measures how many goods and services a person or a machine can produce. More formally, as it is measured by the U.S. Bureau of Labor Statistics, productivity measures how efficiently inputs are converted to output.[1] Inputs are defined as the resources and tools needed to create goods and services. Outputs are the actual items produced. The more productive a person or a company is, the more goods and services it can produce.

Companies evaluate their supply chain, operational processes, and technological efficiencies to work smarter and faster. Employees become more productive through additional education and training, and by learning new skills. More productive employees have historically earned more, and more productive companies have enjoyed higher profits than their peers, which translates to a higher standard of living.[2]

Q: Evidence suggests that the more productive a person or business is, the better off they are economically. Is this accurate?

A: Yes. Let’s take the simple example of a pizzeria. The more pies we sell, the more revenue we generate. Our inputs are ingredients, energy to heat the ovens, and labor in the form of chefs and a wait staff. Let’s say that we have a special recipe that everyone in the neighborhood wants, and they will eat as much pizza as we can produce (that would be a nice problem for any business to have). If this magical pizza recipe and our service standards normally produce 40 pies in an hour, but through improvements in our ovens and table turnover, our output jumps to 60 pies per hour, our productivity just jumped by 50 percent.

With that extra output, we can produce and sell more pizza. Alternatively, we could choose to produce the same number of pies as our original output, but since it would take less time to produce 40 pizzas, we can use that extra time to promote our pizza to other neighborhoods or just call it a day and go see a movie, which of course benefits the theater I may not have gone to had I not improved my productivity time.

Q: What are current productivity trends?

A: Figure One shows year-over-year American labor productivity changes. The blue line represents annual percentage changes, and the dashed line is a long-term trend line, which measures the data’s general direction. Immediately following World War II, labor productivity showed considerable expansion for reasons easy to intuit; people went to school for more training, businesses focused on process improvements, and technological advances started to permeate the workplace. Except for a brief dip in 1956, productivity increased every year until 1974. The mid-1970s and early 1980s saw a challenging economic environment, but labor productivity has been positive every year since 1982. Improved computing power and accessibility, information technology advances, and further supply chain enhancements have contributed to a favorable productivity backdrop.

Figure One: U.S. Labor Productivity Change (Since 1950)

However, the data’s trend line reveals a concerning development. The overall trend moves from the upper left (higher productivity) to the lower right (lower productivity). Data for the rest of the world is not much better. Figure Two below graphs productivity of the Group of Seven (G7) nations—the U.S., Japan, Germany, the UK, France, Italy, and Canada. As you can see, this trend line for these industrialized democracies also slopes from the upper left to the lower right.

Figure Two: G7 Annual Change in Productivity (Since 1971)

Q: Clearly we have an issue in the U.S. and abroad. But how important is productivity? Isn’t productivity one variable among many?

A: Economists emphasize how critical productivity growth is for all countries. U.S. Federal Reserve Vice Chairman Stanley Fischer recently declared, “there are few issues more important for the future of our economy, and those of every other country, than the rate of productivity growth.”[3] Fischer explains why small percent changes make a real difference:

At a 1 percent growth rate, it takes income 70 years to double. At a 2 percent growth rate, it takes 35 years to double. That is to say, that with a growth rate of 1 percent per capita, it takes two generations for per capita income to double; at a 2 percent per capita growth rate, it takes one generation for per capita income to double. That is a massive difference, one that would very likely have severe consequences for the national mood, and possibly for economic policy.[4]

Back to our pizza parlor, the multiplicative effects of productivity start with the individual worker or business and expand out to the broad economy. Higher productivity leads to more sales, more tips for the waiters, and even more leisure time that may generate sales for other businesses such as the movie theater in our example.

Q: While the trend line appears to be heading lower, will productivity necessarily continue to decline?

A: While Fischer emphasizes productivity’s importance, other economists weigh in on its fate. Northwestern University’s Robert Gordon published The Rise and Fall of American Growth in early 2016, arguing that, “Economic growth is not a steady process that creates economic advance at a regular pace, century after century.” His central premise is that “some inventions are more important than others.”[5] Gordon focuses on total factor productivity (TFP), which measures how quickly output grows relative to both labor (workers) and capital (machines and financial assets). Gordon claims that TFP’s anemic performance since 1970 is a function of inventions “channeled into a narrow sphere of human activity having to do with entertainment, communications, and the collecting and processing of information.”[6] Figure Three shows Gordon’s assertions graphically.

Figure Three: U.S. Total Factor Productivity Change (Since 1948)

Others, including MIT economists Erik Brynjolfsson and Andrew McAfee, disagree that innovation’s best days are behind us. In their book The Second Machine Age, the authors assert that the steam engine was the pivotal invention behind the Industrial Revolution, and “the key building blocks are already in place for digital technologies to be as important and transformational to society and the economy as the steam engine.”[7] Just as the steam engine was improved over time, the authors note, so too will computing powers and digitization improve over time.

Further, the digital transformation will create a different type of economy than what we are all used to, so while adjustments will follow, “it’s an inflection point in the right direction—bounty instead of scarcity, freedom instead of constraint—but one that will bring with it some difficult challenges and choices.”[8] The authors offer that the impact of technological advances will be wide-ranging, touching everything from transportation to medicine to food, a counter to Gordon’s view on how narrow advancements have been since 1970.

Q: So who is right, and what is the tie-in to the capital markets?

A: Those are the central questions. As we have discussed in prior articles, economic growth is not a great predictor of equity market and other risk-asset performance.[9] However, since productivity has such a large impact on economic growth, labor and total factor productivity’s declining trend concerns central bankers, especially given our weak economic growth results since the financial crisis. This remains a central-bank-driven capital market environment, meaning stocks, bonds, currencies, and commodities are all highly dependent on what central banks communicate about their policies. As the quote from Vice Chairman Fischer suggests, central bankers are hyperfocused on productivity trends. 

We see value in both Gordon’s argument about innovations and McAfee’s perspective on digitization. However, demographics of industrialized nations suggest weak population growth compared to the last 100 years, which means that total factor productivity will be even more reliant on capital efficiency. Capital efficiency is ultimately a deflationary phenomenon, with advancements leading to lower prices and not necessarily leading to higher wages.

Thus, we see central bankers remaining very accommodative with policies, remaining on the side of easier access to capital and less likely to raise interest rates. This tends to be favorable for stocks, and for the time being, it is friendly for bonds as well, but we remain concerned about bonds’ future return prospects—especially relative to investors’ expectations based upon their recent experience.

Major central banks, including those in the U.S., Europe, Japan, China, Switzerland, and England, have maintained pro-growth orientations since the depths of the financial crisis. These policies have extended a tepid economic recovery and muted the business cycle. We see ourselves toward the tail end of the U.S. economy’s expansion. That suggests assets like high-quality cyclical stocks and parts of the bond market should do well.

We see the risk-reward trade-off becoming more challenging for stocks and bonds alike as we head toward the latter part of this cycle, and while economic growth typically doesn’t tell the asset price story, the current capital market environment suggests otherwise. Central banks drive markets, and they are focused on productivity, a direct corollary to economy growth. Productivity across the G7 remains under pressure, and until the next new thing emerges to propel economic growth, expect a sluggish, late-cycle economic growth pattern to keep central bankers at bay. The biggest risks in the system are capital markets’ dependence on central bankers and central bankers’ limited tool kits. Should their ability to extend the business cycle fail, risks could emerge. We will keep you posted on our readings of these interactions as they develop.

Now go out and do something productive. The economy depends on it.

Sources:
[1] http://www.bls.gov/lpc/. Accessed 10/7/2016.
[2] Ibid.
[3] http://www.federalreserve.gov/newsevents/speech/fischer20160307a.htm. Accessed 10/7/2016.
[4] Ibid.
[5] Gordon, Robert. The Rise and Fall of American Growth: The U.S. Standard of Living since the Civil War. Princeton: Princeton University Press, 2016, pp 2-3.
[6] Ibid.
[7] Brynjolfsson, Erik and Andrew McAfee, The Second Machine Age: Work, Progress, and Prosperity in a Time of Brilliant Technologies. New York: W.W. Norton & Company, 2014, p 9.
[8] Ibid, p 11.
[9] Dimson, Elroy, Marsh, Paul, and Staunton, Mike. Triumph of the Optimists: 101 Years of Global Investment Returns. Princeton: Princeton University, 2002.