Productivity Growth Ahead

The past 8 years have witnessed one of the worst trends in labor productivity of the past century. Human productivity inexorably rises over time as we learn from our losses and invest with innovative management and capital investments to increase labor efficiency and profits. Productivity naturally falls as an economy moves towards contraction as sales fall faster than companies can reduce costs. Every recovery from an economic recession causes a positive spike in productivity as new operating skills and technology are applied before adding new employees. Businesses need to see profits return and backlogs build prior to taking the additional risk of paying higher wages and acquiring new workers.

The 5 year average labor productivity rate falling to less than 0.5% growth, during an “expansion”, brings the rise in labor output per hour back to the early 1980’s rate when Fed Chair Volker enacted inflation crushing interest rates of 20% to counter the decade long repercussions of leaving the Gold Standard. If the US Labor market today was as strong as the White House portrays then we would have above trend wage inflation and sharply rising productivity as CEO’s allocate profits toward capital investments with new machines and capacity expansions. 

productivity-wsj 

The fact is wage inflation is mild, capacity utilization rates are near recession levels and U6 unemployment remains stubbornly above 9%. A further production rebound in the energy and mining sectors are needed for productivity to return to normal growth rates above 2%.

In looking at the next chart covering the expansion phase of each President viewers should ignore the dead cat productivity spike at the start of each recovery phase that have little to do with policy, but instead survival instincts and built in fiscal and monetary guard rails built into our capitalist republic. Until recently, all Presidents have achieved respectable rates of labor efficiency. The mild productivity growth under Obama plummeted the past couple of years as the commodity sector went into recession. 

productivity-12-16

The mantra of businesses since the 2008 mortgage bubble meltdown has been to play defense: reduce capital expenditures, labor and inventories until organic growth returns. While the lower wage service economy recovered toward normal rates, the industrial economy and small business sectors have remained in cost cutting defense mode. Until backlogs and inventories return to expansion mode for a few quarters we would not be worried about any short term overheating of the GDP, despite the strong 3.5% GDP growth of the 3rd quarter.

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Back in 2014 there were signs of a real US recovery accelerating back to a “full” recovery just as the Oil bubble was popped. After almost 2 years of energy influenced commodity contractions we appear to be in a new recovery phase. New orders are back to 2 year highs as inventory restocking and renewed optimism take hold. Over a year ago we forecasted that the 1st quarter of 2016 would be the economic nadir and start of an Oil and industrial materials recovery.With hindsight, the sharp uptick in new orders, exports and production in the 4th quarter of 2016  appear to confirm our outlook. With backlogs still subdued it’s a good omen for an extension in order flow growth.

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After a global stall in trade and contraction in US exports in 2015 into early 2016, we now see signs of export growth back to normal expansion rates spurred by rising commodity prices. While the higher US Dollar and rising interest rates are a negative longer term, they are not as relevant in the “early” part of an expansion cycle. Yes, our economic metrics are still in the middle innings despite over 7 years into an economic expansion. We have yet to revive animal spirits and generate credit tightening levels that always occur long before a recession.

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Now that the energy led commodity cycle contraction is over, those strong economic headwinds have been replaced with mild tailwinds in the 2nd half of 2016 that should continue into 2018. With contracting backlogs and inventories of the past 2 years we would expect production – factory output  – to remain in expansion mode. Most forecasts estimate 2016 GDP as 1.6% and just 2.2% in 2017. We think both outlooks are conservative.
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Long term stock investors should remain 95% in equities looking for additional buying upon procedural delays by Democrats in February/March that reduce speculative expectations and valuations temporarily. A test of 2330 on the SP 500 Index is the next target level once prices surpass the December highs in the 2270’s.

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