If you follow financial news or ask most investors, monthly nonfarm payrolls, retail sales or perhaps consumer prices are typically considered critical U.S. economic releases. These measures provide a good read on the short-term state of the economy, and they do deserve the extra focus. However, over the long term what we believe is most important is potential, i.e. how fast the economy can grow. And that depends on two variables: growth in the workforce and the productivity of that workforce. Given this, should investors be worried about the recent drop in productivity? Probably.
In the fourth quarter of last year, U.S. productivity, defined roughly as output per hours worked, fell 1.8%, as the labor force added workers faster than production increased output. While investors should not lose sleep over one bad number—productivity is a notoriously volatile indicator—unfortunately the negative reading was consistent with a longer-term weakening trend. For all of 2014 productivity was basically flat. Since exiting the recession in 2009 productivity has averaged about 1.30%, a full percentage point below its long-term average.
Why is productivity growth stalling? This is a source of some debate. The optimistic slant is that productivity is actually higher than what the official statistics suggest, but we’re just not good at measuring it. There is some precedent for this argument. Back in 1987 Nobel Prize-winning economist Robert Solow famously quipped, “You can see the computer age everywhere but in the productivity statistics.” Even though productivity remained muted through the early 90s, it eventually surged as the full power of information technology was harnessed.
On the other side of the spectrum is another Robert, Robert Gordon of Northwestern University. In a seminal paper published in 2012, he argued that the current drought in productivity is a secular rather than cyclical phenomenon. The crux of his theory is that recent technological innovations, while fun, don’t have the same kind of significance or impact on productivity as those of previous periods did.
Although I think Professor Gordon’s views may be too dire, it’s hard to ignore the fact that the slowdown in productivity growth predated the financial crisis: productivity has averaged around 1.50% since 2004. While not awful, the deceleration comes at an inopportune time. The other part of the equation for economic potential, workforce growth, has also slowed in recent years and will probably stay sluggish absent a significant increase in immigration, unlikely in the current political environment. Taken together, these factors are a drag on real gross domestic product (GDP) growth and could keep it below the 60-year average for the next few years.
Should an environment of slower economic growth and modest gains in productivity continue in the U.S., what are the investment implications? First, corporate earnings growth is closely linked to real GDP, making performance of domestic companies more vulnerable. Second, because wages typically rise in-line with productivity over the long term, they probably will not pick up as much as the rebound in the labor market would imply without a faster acceleration in productivity (we are already experiencing this phenomenon). Lackluster wage growth means consumer spending, and ultimately earnings for consumer-oriented companies, will also grow at a slower pace. A slower pace of growth should not be construed as a disaster, but it is troubling for the long-term returns of a stock market that is already pricing in the best of all possible worlds.
(c) Blackrock Investment Management