November 2004

The Moment Of Truth For Productivity?

The Moment Of Truth For Productivity?...Although there may be some type of dramatic acceleration ahead for all we know, headline productivity growth has been slowing down rather noticeably over the past three quarters.  With unit labor costs beginning to very slowly inch up from admittedly unusually low year over year growth rate levels over the past quarter or two, accompanied by the snails pace expansion in payroll headcount, it's a good bet that productivity will also remain subdued when the 3Q number is reported ahead.  In fact, how does a 1-2% estimate sound?  We'll have to see what happens.  As you know, productivity growth over the past half decade has been one of the theoretical bedrock supports of the bullish case for both the economy and the equity markets.  You'll remember that in the late 1990's and early part of the current decade, Greenspan could not speak in public without an obligatory mention of the so-called tech inspired productivity miracle apparently happening right before our eyes.  Unfortunately, as it turns out, the only non-believers were tech stocks themselves. 
         

Given that rate of growth in productivity appears to be subsiding as of late, we want to review historical productivity experience in economic expansions past for clues as to just what might lie ahead for the US economy.  Importantly, and in all sincerity, rapid productivity growth over the last few years was indeed a primary driver of the expansion in after-tax corporate earnings.  As you can see in the chart below, the year over year directional change in productivity and after-tax corporate profit growth is highly correlated and has been historically.
        

If forward headline productivity growth continues to slow as it has in the past three quarters, it's a virtual lock that the rate of change in corporate profitability will follow.  And for now, it's due south.

First, let's review some history.  The following table details the average quarterly growth in productivity since 1950.  Although there are many ways to slice and dice the data, we've simplistically broken it down into experience by decade.

At least on face value, the acceleration this decade in productivity growth appears to corroborate Greenspan's view of modern day miracles.  Quite simplistically, productivity is measured as output per hour.  It's a function of labor input relative to the input of capital, with unit labor costs influencing and responding to this tradeoff.  Using the numbers in the table above, average quarterly productivity growth over the 1950-1999 period was 2.1%.  Certainly the jump in the productivity growth rate during the current decade is an eye opener and deserves further investigation.  Before looking back over historical periods, one more quick table we believe will help us understand just what has happened in terms of recent productivity growth.  Here's average quarterly productivity growth broken down by individual years since 1997.

At least up until this year, we have for the most part been on an accelerating path since 1997.  And there is no question that the profits recovery we have experienced in the current cycle has been the beneficiary of this near term trend in productivity.  The chart below chronicles the acceleration in after-tax corporate profits during the first eleven quarters of each economic recovery of the last three decades in indexed fashion.  As you can see, despite the recent hoopla about the amazing recovery in corporate profitability during this recovery, it has really been an experience quite similar to what was seen in the recoveries of the mid-1970's and early 1980's.
      

Certainly the economic recovery profit acceleration outlier above is the corporate profits recovery of the early 1990's.  But to be honest, we believe it is very easily explained.  In the chart below, we're looking at the peak to trough decline in after-tax corporate profits that was experienced prior to each of the economic recoveries we chart above.  It is absolutely clear that the decline in after-tax corporate profits prior to the early 1990's economic recovery was the most shallow corporate profit decline of the four cases.  In essence, in the early 1990's, corporations had less to recover from, so to speak, in terms of the prior profits decline.  Clearly, the pre-recovery profits decline in the early 1980's and mid-1970's were both a bit worse than what we experienced in the current cycle.  We guess the simple message is that the economy can experience significant corporate profit recoveries providing that the prior decline was likewise historically significant.
        

But as we'll see below, this is where the similarities firmly end between our current experience and what occurred in the mid-1970's and early 1980's economic and corporate profit recovery environments.  Although prior profit downturns look similar and corporate profit recoveries are quite similar in trajectory to what we're now experiencing, the factors that ultimately drive productivity are completely different in the current cycle than was the case in either the 1970's or 1980's.  And that suggests there is something very different about the character of the current economic cycle.  Very different indeed.  Quite simply, as we move ahead in the current period, it's a good bet that we're about to face the moment of truth for the supposed miracle that is productivity.  In one sense, we welcome what we expect to be some type of perceptual "moment of truth" realization.  After all, and in all humility and sincerity, new bull markets simply cannot get underway until the supportive myths of the prior cycle are tossed into the dust heap of perceptual belief.

To us, the important question regarding productivity at the moment is, "just how can the corporate profits recovery in the current cycle look so much like the experience of the recovery cycles of the mid-1970's and early 1980's, yet at the same time witness payroll and unit labor cost experience be so wildly different at the moment?"  Before looking for a few answers, a few pictures of life that basically put prior and current recovery cycle experience for payroll employment, unit labor costs and headline productivity advancement together in simultaneous fashion for each economic recovery of the past three decades.  We've updated the payroll chart many a time.  The comparative unit labor cost and productivity charts are new.  As you'll see, all the charts have been created in an indexed fashion so as to fairly compare experience in each cycle.

     PAYROLL EMPLOYMENT

     UNIT LABOR COSTS

     HEADLINE PRODUCTIVITY

Yes, in the current cycle, we're experiencing the best productivity growth of any economic recovery cycle of the last thirty years at least.  And the primary reason for this is that we're currently experiencing the worst payroll and unit labor cost recovery experience of the last thirty years at least.  So although the current recovery in after-tax corporate profits looks quite similar to the profit recoveries of the mid-1970's and early 1980's, the primary drivers for the current profit recovery are completely different than those two prior cycles.  The current cycle is built on dramatic cost cutting.  But that's not the whole story by a long shot.

It's Your Favorite Foreign Movie...As crazy as it may sound, we suggest that the current productivity miracle is almost completely foreign to us.  And we don't mean foreign in terms of some type of anomaly.  We strongly suggest that the current productivity miracle is being driven by what is happening in the interplay between the domestic and foreign economies.  Our bottom line is that we owe the supposed productivity miracle of the moment to our friends in the foreign community.  But we also suggest that before it's over, perceptions regarding domestic productivity will change.  The "miracle", per se, may indeed turn out to be a nightmare.  Here's the thinking.

First, there is no question in our minds that capital spending in the late 1990's clearly set the stage for the late-1990's and early 2000's expansion in domestic productivity.  Capital spending growth relative to total GDP in the late 1990's was quite the anomaly relative to historical experience and was centered largely in tech.  Tech spending that was to allow many a corporation meaningful forward cost efficiencies.  And in terms of the influence on forward productivity, remember that productivity is in large part driven by the labor versus capital tradeoff, capital usually being the less expensive of the two.  Our late 1990's experience was one of significant "capital deepening".  As you can see below, there have been two periods in the last half century of meaningfully explosive growth in corporate capital spending (a proxy for corporate capital spending being non-residential fixed investment).  The occurrence in the mid-to-late 1970's was all about spending on energy infrastructure.  Although it was necessary to address spiraling oil costs, capital spending at the time did little to make corporate America more efficient, or productive, in a broad sense.  The explosion in capital spending during the 1990's was all about making corporate America more efficient as it was almost exclusively centered in tech spending.  Hardware, software, communications equipment, etc.  As opposed to the experience of the 1970's, the capital spending boom in the 1990's was almost certain to enhance broad productivity gain possibilities in its aftermath.  And enhance productivity it has done.
         

To be honest, the spending in tech in the 1990's was truly a precursor to a better productivity experience ahead.  And indeed it has truly taken place.  We clearly reaped the benefits of this spending early this decade.  Remember the table above that details productivity by year since 1997.  At the end of the cap spending boom in the late 1990's, headline productivity gains began to accelerate like a rocket.  But what we suggest is important is the manner in which this macro capital spending was financed.  Our point is that from a macro context, the capital spending boom of the 1990's was increasingly financed with foreign capital.  Not only was the mid-1990's the point at which our trade deficit began to expand almost geometrically, but the US savings rate likewise began to literally plummet.  We showed you the long term history of US savings just last month.  For all intents and purposes, the current US savings rate is zero.  Throughout the 1990's, the US savings rate dropped like a rock and our dependence on foreign capital inflows increased in sequential fashion with each passing year.  Despite all of the hoopla in the last few weeks about the foreign community slowing its purchases of US financial assets, we believe the following chart puts that short term notion into broader perspective.
      

The bottom line is that the foreign community essentially financed a good portion of the US capital spending boom that led up to the "miracle" of productivity growth in the current cycle.  Could we have financed the late 1990's capital spending boom with US savings as opposed to foreign capital?  Not likely.

Secondly, it is clear that one of the productivity component anomalies of the moment is growth in unit labor costs.  As we pointed out above, there is no economic recovery cycle experience to be found anywhere over the last thirty years at least to compare to what has happened in terms of the lack of  unit labor cost acceleration in the current cycle.  In the following table we update the first table we showed you in this discussion with period specific unit labor cost data.  The numbers tell the entire story in a big way.

There is absolutely no question that unit labor cost experience is a huge driver of the total productivity equation.  Clearly, the two decades to experience the lowest productivity growth, the 1970's and 1980's, likewise experienced the greatest unit labor cost acceleration.  And unit labor cost experience in the current decade is nothing if not striking and a complete outlier relative to historical experience.  Once again, we need look no further than the foreign community for the answer.  It's two pronged.  There is no question that outsourcing has changed the game for unit labor costs in the current domestic economic environment.  Simple and easy to understand.  Great for corporate productivity measures, but is it really great for a US economy almost totally dependent on the consumption habits of its labor force?

The second part of the puzzle that involves the foreign community and domestic US labor costs is intermediate production.  Although many a company has completely outsourced manufacturing and service oriented functions to the foreign community, many have only outsourced intermediate manufacturing or service functions.  A perfect example would be auto parts.  A car might be assembled stateside, but a number of components going into that car may be assembled or manufactured abroad.  The end result is that the domestic labor and unit labor cost component has decreased.  But domestically measured productivity has increased.  Great deal, right?