Market Overview Q316: Production Junction, What’s Your Function?
Markets recovered quickly from the turmoil from the Brexit vote at the end of the second quarter and rode out the summer with exceptionally low levels of volatility. While this oft-repeated pattern has frustrated the efforts of many long term investors waiting for better opportunities, one silver lining is that it has also created an environment of low opportunity cost for investors to investigate longer term investment drivers.
One of those longer term investment drivers is economic productivity. Despite its stature as one of the most important economic metrics, the subject of productivity rarely makes the headlines or inspires public discussion. Partly as a result of this absence, many investors have formed somewhat vague, yet fairly confident, narratives around the idea that productivity is improving nicely due to technology. This is a nice story but one that is incomplete at best, and misleading at worst.
Interestingly, the importance of productivity as a measure of well-being is one of the few areas of consensus in economics; it's just not controversial. As the Bureau of Labor Statistics (BLS) states, "Only if we increase our efficiency—by producing more goods and services without increasing the number of hours we work—can we be sure to increase our standard of living."
There is also fairly wide consensus that productivity growth has been weakening. As the BLS reports, "Productivity growth in recent years hasn’t been as strong, however. It may seem surprising, given all the new technologies and products in recent years, but we are now living through one of the lowest productivity-growth periods ever recorded. Since the Great Recession of 2007–09 began in the fourth quarter of 2007, labor productivity has grown just 1.0 percent per year. That is less than half the long-term average rate of 2.2 percent since 1947."
And this isn't a phenomenon that popped up out of nowhere. The BLS goes on to highlight exactly how pronounced and sustained the downturn in productivity has been: "Labor productivity growth in the nonfarm business sector is lower in the current business cycle than during any of the previous ten business cycles." In other words, despite many investors feeling reasonably optimistic about the economy, the reality is that productivity growth has been eroding for a long time. If trends continue there is a very real chance that future living standards may not rise and could even decline.
There is a compelling body of evidence that identifies various causes of declining productivity growth. The OECD report "The Productivity-Inclusiveness Nexus" noted that, "the types of innovations that took place in the first half of the 20th century (e.g. electrification etc.) are far more significant than anything that has taken place since then (e.g. ICT [information and communications technology]), or indeed, likely to transpire in the future (Gordon, 2012; Cowen, 2011)."
The report also elaborated that, "These arguments are bolstered by evidence of the slowdown in business dynamism observed in frontier economies such as the United States. Gordon (2012) also argues that there are a number of strong headwinds on the horizon that will cause productivity growth in the US to slow further, including ageing populations, a deterioration of education, growing inequality, globalisation, sustainability, and the overhang of consumer and government debt."
While these forces create powerful headwinds for productivity growth, there are also important forces promoting greater productivity. The same OECD report specifically acknowledged the case for optimism. The report notes, "That the underlying rate of technological progress has not slowed and that the IT revolution will continue to dramatically transform frontier economies."
The report went on to note, "According to Brynjolfsson and McAfee (2011), the increasing digitalisation of economic activities has unleashed four main innovative trends: i) improved real-time measurement of business activities; ii) faster and cheaper business experimentation; iii) more widespread and easier sharing of ideas; and iv) the ability to replicate innovations with greater speed and fidelity (scaling-up). While each of these trends is important in isolation, their impacts are amplified when applied in unison."
In addition, it is also important to note that the negative trend in productivity growth may appear worse than it really is due to measurement problems. There is no doubt that as new technologies, big data, and platform business models have become ever larger parts of the economy that conventional measures of physical output may not perfectly capture these changes. While it makes sense to keep this caveat in mind, it does not support a case for completely ignoring the troublingly negative trends in productivity.
The presence of both positive and negative influences on productivity is also clouded by the presence of both shorter-term, cyclical and longer-term, secular forces. According to the OECD, the great concern is that, "Against a backdrop of increases in income and wealth inequalities ... this may reflect a structural, and not a cyclical, slowdown." Indeed, the prospect of a "structural slowdown in productivity" ought to send the risk antennae of long term investors quivering.
In order to disentangle these issues, The Economist provided a useful overview: "The most important determinants of longer-term productivity growth are the rate of adoption of existing and new technologies, the pace of domestic scientific innovation and changes in the organisation of production."
The OECD's Productivity-Inclusiveness report also noted that, "One possible explanation suggests that the main source of the productivity slowdown is not the slowing of the rate of innovation by the most globally advanced firms, but rather a slowing of the pace at which innovations spread throughout the economy: a breakdown of the diffusion machine (Andrews, Criscuolo and Gal, 2015)"