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Productivity: The secret sauce of the economy


When rising productivity coincides with a growing labor force, productivity’s benefits for economic growth are amplified.

Dave Gilreath: ©Sheaff Brock Investment Advisors

Dave Gilreath: ©Sheaff Brock Investment Advisors

The stock market has started the year quite strong, fulfilling bullish expectations and confounding bears issuing a litany of negative forecasts. Although bears’ yearlong calls for a market-dunning recession have proved dead wrong, their unshakable orthodoxy of pessimism nevertheless continues, unaffected by market indexes’ hitting new all-time highs this year amid sustained economic growth.

Finally succumbing to the weight of ponderous evidence, many of these people have recently stopped using the “R” word and “imminent” in the same sentence. Now, many in the habit of trivially belittling the remarkably strong economy obsess over “slowing growth” as if to say, “See, we were (sort of) right.”

Sure, the Energizer bunny of the U.S. economy has slowed in recent months, but this is the inevitable result of one of the most rapid series of interest rate increases ever undertaken by the Federal Reserve Board to tamp down growth to reduce inflation. Yet this slowing has not discouraged stock investors propelling a now-robust market.

So far this year, the normal yin/yang dynamic of inflation and economic growth is not working out for these negativists. Over the past 18 months, inflation has decreased rapidly despite strong growth.

Things are not normally supposed to work out this way. Generally, strong growth is historically fertile ground for inflation — with increasing business activity leading to higher prices and wages, leading to even higher prices. Inflation (the annualized rate of price increases) hit a 40-year high of 9.1% in mid-2022 but is now approaching the Fed target of 2% on pretty much everything except housing. Once that comes down, the Fed will be able to hit this target — or overshoot it, as freighters do not turn on a dime.

Rising productivity

So how can inflation be decreasing amid economic growth and low unemployment, which should be pushing it the other way? The answer is rising economic productivity. This is a nerdy economics term for the ratio of economic output to input — the amount of goods and services produced by the economy relative to the amount of labor used to produce them.

When rising productivity coincides with a growing labor force, which is often the case in the U.S. because of its globally high immigration, productivity’s benefits for economic growth are amplified. Rising productivity reflects an economy in harmony, where wage increases keep pace with rising prices, counteracting growth’s normal tendency to push up inflation.

Like most other economic factors, productivity is measured in long cycles. There are strong indications that the nation’s currently increasing productivity is now on a long uptrend.

If these indications continue, they will amount to a cumulative “gotcha” moment for economic and market Cassandras now opining that continued economic growth would irrevocably mean rising inflation. And rising or persistent inflation would disincline the Fed from cutting interest rates, likely impeding stock growth.

Many economists now believe that the biggest potential upside to the economy is continued strong productivity, and that the biggest potential downside is the Fed’s keeping interest rates too high for too long. Although the ordinary perception is that interest rate cuts benefit stocks, the historical reality is that the first cut in a series starts the clock ticking for a correction or an even deeper market decline down the road.

Strange environment

We are in a strange environment where a strong economy — fertile ground for stocks — is being shunned by short-term investors worried about how economic conditions might translate into Fed actions that could slow market growth, if only for a couple of quarters. As sound economic conditions are essential for companies to grow, investors who find them inconvenient are like actors in an absurdist play. The chorus in this sullen production consists of short-termers waiting for a negative shoe to drop. That shoe is sustained high inflation, which would delay anticipated interest rate cuts by the Fed.

These negativists got excited in early February by data showing a slight inflation uptick in January, although they know full well that economic trends rarely, if ever, follow straight lines on charts. Over the longer term, this statistical twitch will likely prove to be nothing more than a tease for those seeking justification for their negative prognostications.

Continued rising productivity may render all this hand-wringing moot. Various economists now point to historically high productivity increases over the past 18 months, indicating a likely sustained upcycle. Since mid-2022, productivity has increased about 3% in three consecutive quarters — well above historical averages.

Some economists point out that the current economy is completely unlike that of the inflation-wracked 1970s, when productivity growth was quite low (hovering around 1% annually). Today, they say, conditions are more like those of the mid- to late 1990s, a period of high economic growth with a rocking stock market and rising productivity.

Secret sauce

Ed Yardeni, a market economist renowned for the accuracy of his forecasts, views productivity as the “secret sauce” for economies. He traces the origins of current gains to 2015, when productivity began trending upward. Then, in 2020, pandemic shutdowns “derailed this productivity boom.” Now that the overall economy has regained its prepandemic footing, Yardeni says, forces propelling earlier productivity are again getting traction, auguring likely strong growth over the next few years.

This, along with stock market gains, creates a scenario ripe for what Yardeni calls the Roaring 2020s, an allusion to the huge economic gains of the Roaring ’20s in the 20th century, when the nation rebounded from the impacts of World War I and the Spanish flu pandemic in what President Warren G. Harding famously called a return to normalcy. Yardeni sees significant potential for a similar return to normalcy in the 2020s, now that the economy has recovered from the economic aftermath of the COVID-19 pandemic and the market has recovered from the bear of 2022.

A key factor in productivity increases is the degree to which technology advances enhance labor output. Tech advancements of course replace human workers through automation, but they also amplify or accelerate the work of humans, enabling them to be more productive.

Investors are clamoring for stocks that have anything to do with artificial intelligence (AI), widely viewed as a potential driver of productivity. Yet Yardeni believes the economy is poised for greater productivity, with greatly increased industrial output, even without AI.

In the 21st century, many nontech companies have significantly increased their productivity with basic computer technology and more recent advances, including robotics used in manufacturing. In the stock market’s industrials sector, the result is traditional industrial companies that are far more technologically enabled than many investors may believe.

Boosting human output

Current speculation about AI’s impact on productivity centers on its latest iteration, generative AI — software that autonomously determines how to learn, create, invent and modify. Much is now being made of the potential for generative AI to replace workers, but its impact may turn out to be simply making human workers more productive. That modest prospect has been suggested by none other than Sam Altman, the tech visionary behind ChatGBT, the generative AI platform for text creation that has attracted no small amount of attention during the past year.

On a more microeconomic level, as generative AI transitions from concept to actual applications, it will be easier for investors to assess its potential for profitability in specific industries. Adapting new tech like generative AI to its best uses is a quantum leap in the digital revolution, the current epochal period of technological advancement that is proving every bit as impactful as previous revolutions — including steam, railroads and oil, all of which greatly enhanced economic productivity, driving economies and markets.

As successful investing involves recognizing market drivers when they emerge, those who nurture negative, low-growth scenarios are probably at a disadvantage when it comes to investing in productivity. By contrast, investors willing to accept good news and acknowledge productivity’s benefits are in a better position to trade on it.

Dave S. Gilreath, CFP, is a founding principal and CIO of Sheaff Brock Investment Advisors, an investment firm for individual investors, and Innovative Portfolios, an institutional money management firm. Based in Indianapolis, the firms manage assets of about $1.4 billion. The investments mentioned in this article may be held by those firms, Innovative Portfolios’ ETFs, affiliates or related persons. There may be a conflict of interest in that the parties may have a vested interest in these investments and the statements made about them.

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