Too little, too late
Avoid distractions, drive MONO. This motto, created for the current road-traffic safety campaign in the Netherlands, could well turn out to be perfect advice for investors. Rising interest rates, Italy, Brexit, the trade impasse between China and the US, plummeting oil prices – these are the topics dominating the headlines. They are also topics that can distract investors to such a degree that they fail to achieve their long-term investment goals.
And although it may be an opportune moment for some tactical adjustment, navigating towards long-term returns primarily requires a healthy focus on the course you plotted beforehand. Rather than prevailing market sentiment, ultimately the roadmap for investors is more likely to be determined by the expected development of the economic cycle and the ‘reaction function’ of central banks.
There is strong consensus that we are currently in the late phase of a global economic expansion. True to form, markets are anticipating key turning points in the economic cycle. And although we’ll only be able to find out – with the benefit of hindsight – whether we are indeed in a late phase of the economic upturn after the fact, investors are already eagerly searching for indications that suggest an imminent recession and the associated bear market in risky assets.
Given this frame of reference, pundits are now quick to point to plummeting oil prices as an ominous sign of a global decline in aggregate demand and to rising interest rates as a dampener on equity markets.
There is, however, one topic that has failed to hit the headlines recently and that suggests the expansion still has some way to go yet: productivity growth. This week’s graph compares growth in US labor productivity with how much companies are expecting to invest. Productivity growth appears to considerably lag corporate capital expenditure.
The turquoise line, indicating capital expenditure, is almost three years ahead of productivity (the orange line)! Understandably, it was the then-future Nobel Prize winner Solow who in the 80s said that “you can see the computer age everywhere except in the productivity statistics”. It takes quite some time for companies and employees to fully embrace and make use of new technologies and ways of working.
Strikingly, we can see a sharp rise in the turquoise line. This reflects the recent tendency among companies to make larger investments in machinery and new technology (such as artificial intelligence and blockchain) relative to the number of hours worked by employees (a process called capital deepening). Capacity utilization rates have risen, and very tight labor markets (especially in the US) are again making it attractive to substitute increasingly expensive labor with capital.
You could surmise from the increasing capital expenditure that we can at last expect a boost in productivity and that ongoing digitalization will pay off in the coming years. This would be good news for companies, as it can lower labor costs per unit of product and keeps earnings growth on course. A continuation of the flourishing earnings picture (S&P 500 earnings growth of 28% YoY in Q3!) is pivotal for the continuation of this equity bull market.
An acceleration in productivity growth would elicit sighs of relief both in boardrooms and among central bankers. Productivity growth prevents economic overheating and eases inflationary pressures, reducing the need for central bankers to intervene heavily with interest rate hikes, thereby prolonging the economic expansion.
Looking ahead, alas, the welcome distraction that productivity growth could provide will probably prove to be a typical case of ‘too little and too late’. The US economy is already firing on all cylinders, and the Fed won’t disregard signals of overheating next year in the belief that an uptick in productivity growth could be around the corner.
Ultimately, with the supply side of the economy too slow to respond, the Fed will have to step in and rebalance the economy by hiking rates further and thus slowing down aggregate demand. The matrix signs for the global economy are still flashing green, but if you’re driving in the fast lane, you might want to tighten your seatbelt as 2019 unfolds.
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