Among the countries that make up half of the world economy, productivity growth has remained unusually sluggish for the past five years.
Slower productivity growth may lead to the return of inflation, a shortage of tax revenue, pressure on profit margins, and less “creative destruction.”
This potential long-term theme may lead investors to find bright spots among mega-caps and emerging market stocks and to avoid those investments that are interest-rate sensitive.
A debate has been raging among economists over whether the recent slowdown in productivity growth in the United States and elsewhere is being measured correctly. Research from Wall Street, the Federal Reserve, think tanks, and academics cite conflicting reasons for why the growth rate of output per hour is probably not accurate, but most agree that the measurement itself has always been flawed. The focus for investors shouldn’t be on the exact number, but instead on the general trend that productivity is lower now than in the past, as you can see in the chart below. If productivity growth remains lower in the years ahead, there are five key strategies for how investors may be able to get the most out of slower growth.
Productivity growth has slowed in G7 countries
*Growth of Labor Productivity per hour worked, percent change for the G7, weighted by GDP in 2014 US dollars
Source: Charles Schwab, The Conference Board data as of 5/5/2016.
What is productivity?
Productivity growth is a measure of the annual improvement in how people, combined with technology and materials, produce the goods and services that make up an economy. In other words, how much more we are producing with the same resources than we did last year.
Why does it matter?
Since the number of hours in a day isn’t changing and the global labor supply doesn’t change dramatically from year to year (although long-term demographic trends do have an impact), our ability to increase output and improve living standards is heavily dependent upon productivity growth.
For some countries, productivity growth is more essential to the economy than in others. In the United States, continued labor force growth helps the economy expand. In Japan, the working age population is in long-term decline (although in the past few years the labor force has temporarily stabilized thanks to married women entering and elderly workers remaining in the workforce). If productivity cannot rise to offset the declining workforce in the decade ahead, Japan’s GDP growth, which has averaged less than 1% over the past 15 years, may turn negative and enter a permanent recession.
For businesses, productivity means profits. The more that can be produced and sold per input translates to higher profit margins and faster earnings growth.
When did it slow?
Productivity growth failed to sustain a brief rebound in 2010 after the global economic recession of 2008-09. Among the countries that make up half of the world economy, known collectively as the Group of Seven (G7) (United States, Canada, United Kingdom, Germany, France, Italy, and Japan), productivity growth has remained unusually sluggish during the past five years.
How slow is it really?
Productivity growth has averaged only 0.5% over the past five years after averaging 2.0% over the preceding 35 years from 1975 through 2010.
It can be argued that the productivity number is higher than reported due to created value that is hard to measure. While today, the unmeasured value of better information accruing from the rise of the internet may be sizable, so too were the unmeasured communication and health benefits from radio, automobiles, antibiotics, indoor plumbing, and air conditioning. The mismeasurement of productivity is not just a recent development, and so does not account for the recent slowdown in productivity growth.
Where are the opportunities and the risks?
Hopefully, in the years ahead, we may see productivity rebound on either a revival of capital investment or on more consistent growth across the major world economies. But, if not, here are five longer-term impacts of slower productivity growth:
Return of inflation – The slowdown in output per hour in recent years has overlapped with recessions in Europe and Japan, weighing on global demand. This weakness in both supply and demand has allowed inflation to remain low. Slower growth in output per hour over the long term can eventually lead to higher inflation, as output grows more slowly relative to demand. For example, countries that have had below average productivity growth over the past 25 years, such as Venezuela, Brazil, Russia, and South Africa, have also tended to have much higher than average rates of inflation. Investors who want to guard against inflation should gravitate toward industries that benefit directly from it, such as energy and materials as well as companies that produce consumer staples. These companies stand a better chance of passing along higher costs to consumers.
Shortage of tax revenue – Slower economic growth in some countries may mean that tax revenue may not grow fast enough to meet pension and healthcare needs, straining budgets and deepening worries over high debt levels that could push interest rates higher. Investors may want to limit their exposure to stocks in industries dependent upon government spending like defense and in the interest rate-sensitive utilities and telecommunications services sectors that have outperformed the global markets so far this year, measured by the MSCI World Index.
Emerging market growth – Economic growth, represented by GDP growth, can be calculated by the sum of the growth in the labor force and the growth in labor productivity. Developed market economies are being forced to contend with the double challenge of slow to negative labor force growth and slower productivity growth. In contrast, emerging market economies have much faster labor force growth, on average, and have not seen a slowdown in productivity growth in recent years, as you can see in the chart below. While there may be a lagged slowdown yet to be felt in their productivity growth as emerging markets adopt past developed market innovations, there appears to still be more to come. For example, improvement in India’s poor road and rail infrastructure may continue to lift productivity for the near future. Investors may be able to find better and increasingly more efficient growth among the emerging markets.
Productivity growth in developed market economies has slowed from long-term averages but not so in emerging market economies
Source: Charles Schwab, Conference Board data as of 5/27/2016.
Profit margin pressure – Over the long-term, lower productivity growth can mean faster growth in labor costs, which could pinch profit margins. Investors may want to favor those sectors that can more easily substitute technology for labor or are less exposed to labor costs as a percent of total costs. Retailers in the consumer discretionary sector and makers of machinery in the industrials sector have demonstrated an ability to manage labor costs through technology.
Less creative destruction – It is worth noting that a few of the top ten companies that make up the MSCI All Country World Index of global stocks (Amazon, Facebook and Alphabet) have been around less than 20 years and the “creative destruction” they embodied displaced slower growers from the top spots. But, looking ahead, to the extent that slower productivity growth is due to slower pace of innovation or adoption of new technologies this could benefit the currently dominant, mega-cap, companies as they face fewer upstart challengers. Coinciding with the slowdown in productivity growth is a drop off in new business startups, as you can see in the chart below. For investors this may mean favoring the mega cap stocks over smaller competitors since current leaders may not be displaced as quickly or have their market position challenged as aggressively which may push their valuations higher as they sustain better relative profit growth.
Fewer new business startups may benefit current industry leaders
Source: Charles Schwab, U.S. Census Bureau data as of 5/27/2016.
Making the most out of a slower growth environment may help define investment success in the coming years. The pace of productivity growth will be important to monitor and adapt to as conditions evolve. This potential long-term theme may lead investors to find bright spots among mega-caps and emerging market stocks.