A More Productive Way to Look at Productivity

Are we in a productivity recession? Per the Bureau of Labor Statistics, labor productivity has fallen for three straight quarters-the longest slump since the late 1970s-after experts anticipated a gain in Q2. Cue the related concerns about productivity and the potential knock on overall economic growth. However, though the media portrays weak productivity as a sign of broader weakness-a common meme throughout this bull market-the gauge itself isn't very telling, and it isn't predictive for stocks.

Folks focused on nonfarm business labor productivity, which contracted -0.5% annualized in Q2. A quick primer: To calculate labor productivity, divide output by hours worked. Output of nonfarm businesses comprises approximately 75% of US GDP, while hours worked refers to time spent producing goods and services in those related sectors. Both inputs rose in Q2, but hours worked rose more (1.8% vs. 1.2%).

Those concerned about productivity posit growth is a product of increased hiring-more bodies doing work-and therefore a mirage, not a sign of a robust economy firing on all cylinders. However (and excuse the tautology), growth is growth, and productivity normally ebbs and flows. It would be unrealistic to expect businesses to make efficiency gains quarter in, quarter out. Often, when a firm upgrades software or equipment, they get a near-term efficiency boost and then live off it for a while, until the time comes for a new upgrade or until circumstances force them to get creative. Necessity is the mother of invention, after all. Firms usually cut costs and find ways to do more with less when times are bad, so productivity gains tend to be highest at the beginning of a recovery. (Exhibit 1)

Exhibit 1: Labor Productivity Since 1947

Source: FactSet, as of 8/10/2016. Labor productivity of nonfarm businesses, % change from a quarter ago, seasonally adjusted annual rate, from Q2 1947 - Q2 2016. Recessions as defined by the National Bureau of Economic Research.

While this chart is a bit messy, that's by design, as it shows another key point-no level of productivity growth is inherently bullish or bearish. Nor is productivity predictive: Two backward-looking indicators don't magically combine into something forward-looking. There is no econometric alchemy. Productivity bounces wildly during expansions, frequently dipping negative, and the last three quarters aren't abnormal by any stretch. As expansions mature, firms become more confident about the future and hire folks, regularly causing productivity growth to flag a little bit. In more mature expansions, there is simply less incentive to be lean and mean. Firms can afford to execute long-term business plans and staff up to do so.

Some say this staffing up-alongside falling productivity-is a sign of corporate bloat, that costs are rising and pressuring earnings. In some cases, perhaps that's true. But overall and on average, demand is rising as the economy grows, and if firms have to hire more to keep up with it, that isn't a bad thing. To the extent it raises costs and perhaps pressures margins, it's normal for revenue growth, not cost-cutting, to drive earnings later in the cycle. Again, the incentives are different. It doesn't mean firms are overstretched-they're still profitable-but they aren't in lockdown. That's good, not bad, and note, revenue growth exceeds earnings growth today. Plus, there is no direct relationship between earnings and stocks as low earnings don't mean stocks fall, just as high earnings don't guarantee a stock pop. Instead, how investor expectations square up with reality matters much more.

Some see this differently, warning productivity is falling because businesses haven't invested in labor-enhancing capital equipment-putting the economy at a disadvantage moving forward. However, weak business investment is largely confined to specific areas of the economy, like the flagging Energy sector. Investment in mining exploration has cratered over the past six quarters, plunging -57.8% annualized in Q2.^[i] But investment has been stronger elsewhere. Industrial equipment rose 12.0% in the most recent quarter and was positive in 7 of the past 10 quarters. Software investment has an even more impressive long-term trend, up in 9 of the past 10 quarters while rising 4.4% in Q2. Information-related equipment fell -5.9% in Q2 but was positive in 5 of the past 10 quarters. These investments might not immediately boost worker output, but they have been growing overall for a while-a sign of businesses' commitment to the future.

Then again, some gains might not show up in the official productivity measure. The gains in today's services- and consumption-based economy aren't easily captured by a gauge first published in 1959, when manufacturing was a larger slice of US economic activity and the Internet was closer to science fiction than reality. Consider what the typical computer is capable of now: word processing, data crunching and presentation creation-and that's not including the Internet's bountiful resources! However, these gains aren't so easily measured, at least through existing metrics. Last we checked, GDP's categories don't include "data crunched," "reports written" or anything similar. It merely tallies the money spent throughout the broader economy. It can show the money spent at service firms that perform these tasks more efficiently, but it can't tell you how they contributed to that spending. Someday, we may have the tools to assess modern productivity.^[ii] Until then, we use what's available, limited as it may be.

The fretting over contracting labor productivity is largely in line with the typical reaction to economic data these days. Throughout the expansion, folks have constantly been on watch for data saying the expansion's end is nigh. US recession fears were common earlier this year, even though leading economic indicators suggested growth would continue. Globally, folks see weakness everywhere, from the eurozone to China. Yet despite some weak pockets, the global economy has largely chugged forward-an underappreciated positive. The US economy is at the forefront of this expansion, and despite constant doubt and questions, we believe it will continue for the foreseeable future-a bullish development.