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After a long slump, productivity growth is accelerating again — and the reasons for the acceleration further reinforce our view that we are in a late, bullish phase of the economic and market cycle, with more upside to come for stocks. As we have said many times in recent months, “This bull market is not dead” — and this is further evidence to support our thesis.
We’ve written a lot about productivity growth and the reasons for the slowdown of the last several years. That slowdown has been a key component of the lackluster GDP growth that has dogged the U.S. economy in the years following the Great Recession. In simplest terms, productivity drives GDP; GDP drives corporate profits; and corporate profits drive stock prices. That’s why we watch productivity trends — to give us an important large-scale perspective on the economic dynamics within which the market is operating.
Economic theory is only useful, from our perspective, if it gives an investor the insight to avoid a major decline, the courage to stay in a bull market, and the wisdom to choose stocks that can outperform. If what follows doesn’t make sense to you, please give us a call.
Productivity Growth: What It Is
Below, we’ll say a little about what factors influence an economy’s productivity, how those are now changing, and what it means for U.S. GDP growth, corporate profits, and stock prices.
Put simply, “productivity” measures a society’s resources of land, labor, and capital, and how well it transforms those resources into valued goods and services. Productivity growth tells you how that ability to transform resources into goods is improving over time — which makes the productivity growth trend one of the most important measures of economic health as far as stock-market returns are concerned.
Productivity has three major components:
• “Labor quality”: the skills and qualities of the labor force, such as education, experience, age, and other demographic characteristics
• Capital expenditures, or “capital deepening”: companies making capital investments to give their workers better buildings and equipment to work with
• “Total factor productivity” — basically, everything else: technological innovation, improved efficiency, more efficient allocation of resources, economies of scale
In the years of depressed productivity growth and anemic GDP growth that followed the Great Recession, many observers and analysts struggled to find an explanation of what was going on. Some came to the conclusion that an intractable, long-term, structural process was underway that would keep productivity growth and GDP growth permanently below their previous trends — a depressing “new normal.”
However, we note that it was capital expenditures falling off a cliff is what really dragged down productivity growth in the post-recession era.
Components of U.S. Productivity Growth, 1950–2016
Source: Morgan Stanley Research
What’s Going On Here?
So the real question is Why did capital expenditures crash? Are the circumstances that made them crash now changing? Are they accelerating again? What does that mean for investment prospects in specific industries?
First: New Regulations
One point that we have made several times is that productivity growth slows during periods of large regulatory changes.
When Regulations Go Up, Productivity Growth Goes Down
Source: Deutsche Bank Research
New regulations probably have their primary impact on capital expenditures, as companies put off investment because of uncertainty about future business conditions, and deploy more of their resources to deal with regulatory compliance. So this is certainly one part of the solution to the mystery of the missing capital expenditures.
It is also one that is changing. Despite the public gridlock that has characterized the U.S. political scene over the past year, there have been quiet, ongoing efforts to dial back regulatory burdens in the U.S. This is part of the reason that business confidence has risen so sharply and stayed so high in 2017. We believe that whatever the outcome of strategic, headline political efforts around healthcare and tax reform, this trend of deregulation will continue.
Second: Labor Costs
During the post-recession era, labor got cheap. This was a basic incentive to businesses: faced with a choice between capital expenditures and hiring more labor, they would incrementally choose the latter, since it was relatively cheaper.
Source: Morgan Stanley Research
Morgan Stanley writes: “Between 2011 and 2013, the price of capital rose 3.2 percent per year while the price of labor rose only 1.5 percent per year — a 1.7% annual increase in the price of capital relative to labor… Facing higher relative prices of capital in the post-recession period, companies shifted production techniques from more to less capital-intensive methods and increased their utilization of labor.”
And with unemployment having fallen to (or perhaps below) what is typically thought to be a “full employment” level, wages have begun rising and are expected to continue rising, and businesses’ calculations are showing signs of changing in response.
Source: Morgan Stanley Research
Facing profit pressures from rising wages, companies will seek to maintain their profit margins by beefing up capital expenditures (which will make their existing workers more productive).
This is already happening: real equipment investment will likely expand in the fourth quarter of 2017, making the fourth consecutive quarterly increase and breaking a downtrend in place since 2011. In September, the notes from the Fed meeting made the same observation, saying that “tight labor markets were increasing the incentives for businesses to substitute capital for labor or to invest in information technology.”
So there’s another reason why the “missing capex” is starting to appear again… And will likely bring with it an acceleration in productivity growth.
Third: The Sunset of Extraordinary Monetary Policy In the U.S.
A final factor worth considering in the mystery of the missing capital expenditures is the effect of extraordinary monetary policy and suppressed interest rates that have characterized the post-crisis period.
With low interest rates borrowing was inexpensive, and with executive compensation largely based on stock prices, it made sense for many large corporations to lever up and spend on stock buybacks rather than investing for organic growth. Indeed, corporate stock buybacks have dwarfed other buyers of U.S. stocks on balance since 2008, as you can see on the chart below.
Source: Canaccord Genuity
As we move slowly out of the “extremely accommodative” period into a merely “accommodative” period of monetary policy, this will also slowly change, with large corporates gradually directing less cash to buybacks and more cash to capex investments to generate organic growth — especially in the context of rising labor costs noted above.
Capital Expenditures and Productivity Growth Likely To Accelerate
All these factors will likely mean acceleration in capital expenditures, which in turn should drive accelerating productivity growth, accelerating GDP growth, and accelerating corporate profits. This supports our bullish view of U.S. growth and market appreciation for the duration of the cycle, which could be another one or more years.
Investment implications: Some industries which will likely be ramping capital expenditures in the coming year will be doing it not simply to remedy a previous deficit. These include some of our favored industries in the U.S., including technology, computer hardware and software, semiconductors, e-commerce and related logistics providers, social media, and consumer technology. Companies that have lagged in their capex will turn to tech firms to use their software and hardware in their quest to boost productivity and maintain their margins as wage pressures increase.
To learn more about Guild Investment Management, please go to www.guildinvestment.com.