Productivity growth has been weak since the financial crisis, but recent data suggests the tide has turned. Why that's good news for equities investors.
Of all available measures, productivity is widely accepted as the single most important indicator of an economy's health. But over the past six years, annual U.S. productivity growth averaged a mere 0.6%, confounding both economists and investors alike. Indeed, many began to question if the rate of growth would remain near zero indefinitely.
Now, the tide appears to be turning.
Labor productivity is on track to increase 1.3% in 2017, and Morgan Stanley economists expect it to remain above 1% over the next several years. The upshot? This turning point implies stronger GDP growth and has far-reaching implications for the longer-term trajectory of interest rates and asset prices across the U.S. economy.
This turning point implies stronger GDP growth and implications for asset prices across the U.S. economy.
Productivity can be thought of as a general measure of an economy’s efficiency. That is, how well businesses combine resources to produce goods and services. The measure is important because there is a strong positive relationship between a nation's productivity and its standard of living, or real GDP per capita. In addition, productivity growth is one of two main inputs (alongside growth in the labor force) that determines the long-run sustainable pace of GDP growth.
One of the key components of productivity growth is what’s called “capital deepening”—the extent to which businesses provide more and better equipment to workers. More and better equipment means more efficiency, and therefore more productivity and higher GDP growth.
After a number of years with little to no growth, labor productivity is now rising. According to a new report from Morgan Stanley Research, this increase is due to an inflection upward in business investment.
“We’re seeing that rising labor costs relative to capital are incentivizing a shift back toward capital investment," says Morgan Stanley's U.S. chief economist Ellen Zentner, explaining that capital expenditures, or capex, pave the way for productivity improvements. Meanwhile, with quantitative easing coming to an end and global economies now growing in sync, markets are finally rewarding companies for putting money back into their businesses.
This is potentially good news for equity investors. The report notes that capital that leads to a rise in productivity is a positive for equity markets for two reasons: The direct effect of increased revenue that flows to businesses, but also that improving productivity often leads to increased confidence.
In the wake of the financial crisis, two trends converged that limited capex and in turn hampered productivity: First, with unemployment rates high, firms opted to hire more labor rather than invest in new equipment. That equation made sense when wages were low, but as the labor market tightens this model is becoming less sustainable.
Factor Prices (percent per year, annualized)
“The rising cost of labor has pressured corporate profits enough to begin incentivizing firms to invest incrementally in capex rather than labor to grow their businesses," says Zentner, noting that in 2015 the price of capital services fell 1% while the cost of labor rose 3.6%. “Looking ahead, we expect the shift from labor to capital to continue as the labor market tightens further and exerts upward pressure on wage growth."
Low interest rates also suppressed capex, which hindered productivity. During quantitative easing, the market punished companies with high capital expenditures while rewarding companies that returned cash to shareholders via stock buybacks and dividends. With the Fed now shrinking its balance sheet, investor sentiment around capex appears to have shifted.
In April, Morgan Stanley's Capex Plans index hit its highest level since 2007 and has remained elevated. Indeed, business investment has been particularly robust in 2017 and equipment spending appears to be on track to grow at a double-digit pace in the fourth quarter, which would mark the fifth straight quarter of increases since late 2011. Investors have taken note and are now rewarding firms for investing to expand productive capacity.
Six Month Capex Plans Composite Index
To identify sectors and industries where capital spending is on the rise, Morgan Stanley combined its top-down research with a bottoms-up analysis derived from its database of U.S. publicly traded companies. One key finding: Service industries are best positioned for capital deepening, growing capex even when there was no prior shortfall.
While service businesses generally aren't very capital intensive, wage pressures are pushing services companies to improve efficiencies with equipment purchases such as productivity software, artificial intelligence technology and smart devices.
Given the large and growing share of the economic pie “an uptick in labor productivity in the service sector could drive overall productivity higher in the coming years," Zentner notes. In 2016, the services sector represented 64% of gross output, up from 40% in the 1950s. Yet, until recently, capex in services remained flat as firms relied on cheap labor to drive output.
In all, Morgan Stanley analyzed 52 industries and identified 28 with above-trend capex; of these, 13 are likely engaged in capital deepening. That group includes such services industries as air freight and logistics, Internet, and health-care providers and services. In manufacturing, capital deepening is evident primarily in technology-related equipment such as electronic equipment, instruments, components, semiconductors and computers & peripherals.
Investors should keep in mind, however, that correlation does not equate to causation. The report notes that just because a company has increased its capex does not mean that productivity will follow. Still, the market has already begun rewarding the capex spenders—and the trend suggests market returns could continue to favor these capex beneficiaries.