Some U.S. economic numbers count more than others. The monthly non-farm payroll report occupies an outsized place in the minds of most investors. In contrast, quarterly productivity numbers often go unnoticed and unremarked.
That’s a mistake. Today, investors are confronted with a troubling puzzle: Despite ubiquitous examples of U.S. innovation, official productivity numbers are unusually low. While productivity growth started to slow before the financial crisis, it has been particularly weak since 2009, averaging barely 1 percent, less than half of the pre-crisis average, according to Bloomberg data. If weak productivity growth numbers are accurate, admittedly an “if”, they’re a problem for most traditional asset classes.
Why does productivity growth matter so much? Productivity and growth in the labor force are the key determinants of a country’s economic growth potential. With demographics, such as an aging population, pulling down growth in the labor force, the U.S. economy is already facing a major headwind, and weak productivity doesn’t help matters. Historically, quarterly changes in productivity growth have explained over 40 percent of the variation in economic growth. In the past, every 1 percentage point increase in productivity has been associated with 0.7 percent gain in real gross domestic product (GDP), according to an analysis using figures accessible via Bloomberg.
The picture becomes even more complicated, as there’s a real debate as to why, or even if, productivity growth has slowed, as The Wall Street Journal recently pointed out. Optimists would cite several benign explanations: The slowdown is temporary or a measurement problem.
Is the Slowdown Temporary?
The first scenario has precedent. Back in the early 1990s, there was a similar phenomenon. In retrospect, that productivity problem was temporary; in the second half of that decade, productivity grew at a +2.5 percent annualized rate, according to Bloomberg data. A similar dynamic may be playing out today, thanks to innovations such as Big Data, 3D printing and robotics.
Are the Numbers Just Not Adding Up?
A second explanation is that we’re already witnessing the improvement in productivity, but we just don’t know it because of a measurement problem. In other words, given the increasing shift to services, and now “sharing” economy, measuring output and productivity has become more complicated. Under this scenario, government statistics simply need to catch up with the real economy.
A Closer Look at Slowing Productivity
The third, less comforting explanation is that the slowdown is real and likely to continue. According to an extreme form of this view, previous periods of exceptional productivity were aberrations and are unlikely to be repeated. The most famous proponent of this view is Professor Robert Gordon, from Northwestern University.
While this may seem to be an esoteric academic debate, slowing productivity growth matters. By lowering potential economic growth, it can lead to bottlenecks and wage pressures, which kick in at lower levels of growth, risking both inflation and higher rates.
Lower productivity can also negatively impact equities. Slower economic growth means slower earnings growth. In addition, lower productivity also implies to lower valuations. Historically, for every 1 percentage point increase in productivity, the multiple on the S&P 500 was 0.32 points higher, as Bloomberg data show.
As of today, the truth is we simply don’t know the extent of the problem. But as I think about the outlook for markets over the next several years, I’m confident that how the productivity puzzle gets resolved will have a greater impact on asset class performance than the next few jobs reports.
Russ Koesterich, CFA, is the Chief Investment Strategist for BlackRock. He is a regular contributor to The Blog.
