The unemployment rate is unlikely to fall much further, eliminating a key driver of growth. Instead, the economy must now rely on higher productivity. But unfortunately, the trends here are getting worse, not better. U.S. GDP growth of around 2% in recent years has generated little excitement. However, we’re now in a position where even that slow pace will be unachievable without a sustained — and highly unlikely — increase in productivity.
What’s causing the productivity crisis?
Economists have been confounded by weak productivity growth. Initially, data quality was blamed for under-representing improvements. Some speculated, for example, that the data failed to reflect technological benefits. But after six years of weak numbers, this is clearly more than a measurement problem.
We believe there are four likely causes for today’s low productivity:
1. Diminishing returns from IT
The game-changing gains from IT hardware are a thing of the past. Although some disruptive technologies like Airbnb and Uber are making a difference, they’re smaller than generally recognized and only make use of existing capital stock, harming investment in new technologies and making other existing technologies less efficient.
2. Globalization and overcapacity
The deflationary pulse from China’s low-cost manufacturing initially made people feel better off. But as overcapacity mounted, the early benefits faded, leaving a lower standard of living and lower marginal productivity.
3. Misallocation of capital
By flooding the economy with liquidity following the crisis, central banks limited the creative destruction that normally drives the next round of productivity improvements. At the same time, the crisis kept many smaller, innovative companies from easily accessing capital.
4. Service economy limitations
As Western economies have become more service-oriented, productivity improvement is becoming harder to achieve. Many service companies have a limit on how productive they are. For example, restaurants can’t eliminate their workforce or no one gets served.
All of these factors have reduced capital spending. After a short-lived post-crisis bounce, companies have been thrifty with spending, choosing instead to buy back shares and pay dividends. Over the past two to three years, capital expenditure (capex) has barely been sufficient to offset depreciation and obsolescent goods and services. Capex and productivity are highly correlated over the medium term, and corporate behavior is taking a heavy toll.
No easy way out
The U.S. economy is at a crossroads as it nears full employment. Wage pressures are building across a large number of industries. Wage bills — the total amount of money that a company pays to its employees annually — appear to be growing at roughly greater than a 3% clip. Wage inflation is bubbling up, and wages are the single most important driver of corporate expenses and profitability.
If productivity fails to improve, profit margins will almost certainly decline. If we assume that top-line growth slows to 0.7% to 1.0%, roughly consistent with potential GDP of 1.5% but a higher labor share of income, and that productivity stalls at 0.5%, corporate profit margins would likely halve in the next 3-5 years. These are figures that will make any investor pay attention.