The Productivity Crash: Time To Pay Attention by Jim Cielinski, CFA – Columbia Threadneedle Investments
As the U.S. reaches full employment, low productivity growth may signal future problems, including higher inflation and decreased profit margins.
Productivity — the measure of economic output per unit of input — has decelerated steadily for the last decade. So why did markets collectively yawn at the news that U.S. non-farm productivity fell at a -1.0% annual rate in the first quarter? Perhaps it was because they have grown accustomed to disappointing news on productivity; or because they’ve managed to thrive for so long in spite of weak productivity trends. Whatever the reason, the time for complacency has passed.
U.S. rate of productivity growth: A troubling downward trend
Two paths to long-term growth
There are two sustainable means of producing healthy, long-term, global economic growth. The first path is through a bigger labor force. More workers — a function of the employment pool and participation rate — allow an economy to produce more goods and services.
The second path is through higher productivity, when the same number of employees working the same number of hours produces more goods and services. The combination of the two is what most of us are accustomed to.
Although productivity growth in most advanced economies has been decelerating for a long time, negative productivity growth is a recent phenomenon. While there was a welcome bounce immediately following the 2008 financial crisis, this was simply a reflection of growth and output recovering from extremely depressed levels utilizing roughly the same pool of labor. The leveling off since 2012 portrays a more structural problem.
Why is this suddenly important today? It’s because the U.S. has now reached, or is very close to reaching full employment. An unemployment rate of 5% or less is widely recognized by policymakers and markets as a non-inflationary speed limit. This puts pressure on the U.S. Federal Reserve to tighten monetary policy or accept higher wage pressures. At the same time, it foreshadows slower growth.
Why you should care
The current economic recovery is one of the weakest on record and productivity is to blame. Quantitative easing owes its prevalence to the disappointing productivity trends, which have in turn restrained growth. Productivity also explains the poor growth in real wages, which has restrained inflation and contributed to income inequality. The key point is this — over the last five years, growth in the U.S. and most developed economies has been driven almost entirely by the falling unemployment rate. So while people are returning to jobs, they’re not being particularly productive.
The U.S. is nearing full employment
Source: Macrobond 2016/Bloomberg 2016
The unemployment rate is unlikely to fall much further, eliminating a key driver of growth. Instead, the economy must now rely on higher productivity. But unfortunately, the trends here are getting worse, not better. U.S. GDP growth of around 2% in recent years has generated little excitement. However, we’re now in a position where even that slow pace will be unachievable without a sustained — and highly unlikely — increase in productivity.
What’s causing the productivity crisis?
Economists have been confounded by weak productivity growth. Initially, data quality was blamed for under-representing improvements. Some speculated, for example, that the data failed to reflect technological benefits. But after six years of weak numbers, this is clearly more than a measurement problem.
We believe there are four likely causes for today’s low productivity:
- Diminishing returns from IT
The game-changing gains from IT hardware are a thing of the past. Although some disruptive technologies like Airbnb and Uber are making a difference, they’re smaller than generally recognized and only make use of existing capital stock, harming investment in new technologies and making other existing technologies less efficient.
- Globalization and overcapacity
The deflationary pulse from China’s low-cost manufacturing initially made people feel better off. But as overcapacity mounted, the early benefits faded, leaving a lower standard of living and lower marginal productivity.
- Misallocation of capital
By flooding the economy with liquidity following the crisis, central banks limited the creative destruction that normally drives the next round of productivity improvements. At the same time, the crisis kept many smaller, innovative companies from easily accessing capital.
- Service economy limitations
As Western economies have become more service-oriented, productivity improvement is becoming harder to achieve. Many service companies have a limit on how productive they are. For example, restaurants can’t, eliminate their workforce or no one gets served.
All of these factors have reduced capital spending. After a short-lived post-crisis bounce, companies have been thrifty with spending, choosing instead to buy back shares and pay dividends. Over the past two to three years, capital expenditure (capex) has barely been sufficient to offset depreciation and obsolescent goods and services. Capex and productivity are highly correlated over the medium term, and corporate behavior is taking a heavy toll.
No easy way out
The U.S. economy is at a crossroads as it nears full employment. Wage pressures are building across a large number of industries. Wage bills — the total amount of money that a company pays to its employees annually — appear to be growing at roughly greater than a 3% clip. Wage inflation is bubbling up, and wages are the single most important driver of corporate expenses and profitability.
If productivity fails to improve, profit margins will almost certainly decline. If we assume that top-line growth slows to 0.7 to 1.0%, roughly consistent with potential GDP of 1.5% but a higher labor share of income, and that productivity stalls at 0.5%, corporate profit margins would likely halve in the next 3-5 years. These are figures that will make any investor pay attention.
What if the Fed pushes back on higher wage inflation to stop these pressures from infiltrating goods and services prices? Fed tightening might allow margins to hold up, but would likely induce higher market risk premiums and/or lead to slower growth, both of which would be damaging to markets.
There’s no easy way out of this quandary. Weak productivity growth leads to weak potential growth, which leads to weak real earnings. This makes it difficult to foresee an outcome that doesn’t produce sluggish growth. Also, in a world of soft global consumption, the strategy many countries are pursuing — exporting their way to greatness — is simply not viable.
Is the situation hopeless? No, there are several scenarios that could help lessen the pain:
- There could be an unexpected turnaround in productivity. It‘s difficult to see where it might come from, but this series is overdue, even if it turns out to be short-lived.
- Policymakers may accept a period of higher inflation. Coupled with excess global liquidity and easy policy, this may bolster growth and strengthen asset markets, so long as policymakers maintain their credibility.
- Labor force growth might accelerate, either through immigration policies or from a higher participation rate.
- Policymakers may turn to fiscal policy to boost growth. This is akin to using leverage to boost GDP, which would breathe some more life into a tired recovery.
Each of these developments is worth watching, although none appear very likely.
Few desirable outcomes
Full employment will place the burden on productivity growth — a weight the U.S. economy may be unable to lift. In Europe, where unemployment hovers near 10%, there is ample room to grow in the face of weak productivity. More workers will be hired but without the accompanying inflationary pressures. A likely outcome would appear to be growth convergence between the U.S. and other advanced economies, but at a slower rate of growth. This may help non-U.S. markets on a relative basis and restrain strength in the U.S. dollar.
The policy response function in this environment is uncertain. How much will the Fed be willing to accommodate an uptick in wage inflation? A larger share of labor relative to GDP, after all, is a welcome development, so long as these trends produce weaker margins rather than higher goods inflation. In many ways, policymakers are flying blind. We expect policy uncertainty to lead to higher volatility.
Collapsing productivity is one reason behind the rise in populist politics. For 10 years, relatively few have reaped the rewards of the recovery. Standards of living have fallen for most workers and exasperation is growing. These developments are also a recipe for potentially higher volatility.
If the Fed remains dovish, bonds, commodities and real assets could benefit. Loose monetary policy by other global economies might allow emerging markets to claw their way back and outpace the lackluster returns of other asset classes. If the Fed chooses to tighten monetary policy, it will likely exacerbate economic fears and restrain hiring plans and real wages. This would hinder consumption and likely lead to losses across risk assets.
Bottom line: Weak productivity growth has reached a critical level. In its early stages, weak productivity is deflationary, as seen in soft real wages, the Chinese slowdown, and collapsing energy prices. As these effects fade and the employment picture tightens, the accommodative policy we have grown accustomed to will become more threatening. Easy money and a productive workforce allow us to produce more goods. Easy money coupled with an unproductive workforce produces slow growth and higher inflation, something markets are ill-prepared for. It’s time to pay attention.