Struggling to be Productive

Risk assets rose last week, supported by the Trump administration’s decision to exempt Canada and Mexico from its steel and aluminum tariffs.  This moderate softening of the US’s stance on trade helped to ease trade war concerns.  US equities were particularly strong this week, rallying 1.74% on Friday, following a US employment report that reflected a surprisingly ‘Goldilocks’ outcome of strong jobs growth with few signs of labor costs overheating.  The February employment report showed a 313k increase in nonfarm payrolls (vs. 205k consensus), but only a 0.1% m/m gain in average hourly earnings (2.6% y/y).  The three-month average for total payrolls now stands at 242k, well above that needed to push the unemployment rate (currently at 4.1%) lower over time.

In past years, employment reports that included strong rates of hiring and modest wage growth were viewed as unambiguously positive for financial markets.  They signaled steady gains in household income, and, in turn, consumer spending (positive for corporate earnings), while subdued inflationary pressures meant little risk of abrupt monetary tightening.  However, at this stage of the business cycle, a lack of productivity growth (at levels near zero) warrants concern.

Going forward, robust rates of employment growth should be viewed as a negative for risk assets because it is a signal that additional output is being generated primarily through additional employment, instead of productivity growth.  This is a negative for because it would imply that the unemployment rate will remain on a downward path, Fed confidence in meeting their 2% inflation target will rise, and concerns about further policy normalization will increase.  On the other hand, a more positive scenario would be if employment growth slows while GDP growth remains robust.  This will likely be a signal of faster productivity growth.  Faster productivity growth would imply an increase in the economy’s potential growth rate, which would elongate the business cycle and support income and earnings, all while keeping inflation at bay.

The drop-off in productivity growth over the past few years was primarily caused by 1) lower capital investment, as corporations substituted away from higher-cost capital to labor (i.e. globalization); and 2) a disincentive for corporate managers to invest during the QE era.  The key to whether or not this ‘Goldilocks’ environment can continue will be determined by productivity growth.  An inflection in productivity would be positive for equity markets for two key reasons: 1) increased revenue and 2) the ability of increasingly productive firms to absorb rising compensation costs and preserve margins.  On the other hand, fixed income securities will likely face pressure due to higher real interest rates (there’s a general rule of thumb that the yield on the 10-Year Treasury should roughly equal nominal GDP, and as yields rise, bond prices fall).

On a positive note, incentives to invest are rising for corporate managers.  As the economy is closer to full employment, rising costs of labor relative to capital are incentivizing a shift back toward capital investment.  Companies are also further incentivized to increase investment following dramatic tax and policy reform.  Reducing corporate tax rates and accelerating depreciation, among other items such as deregulation, should lead to robust capital spending, faster rates of productivity growth, and stronger potential growth.  However, it is always tough to bet on an inflection.

In the near term, investors will be focused on inflation next week as CPI (Tuesday) and PPI (Wednesday) are on the data calendar, along with retail sales (also Wednesday).  Friday’s soft wage number cleared another hurdle for risk assets to recoup February losses, and a near-consensus US CPI would likely extend the recovery.  Upside surprises on the forthcoming inflation data would be a negative as it could prompt FOMC members to adjust their Fed Funds rate expectations at the March meeting.  Fed Funds futures rates are pricing in a nearly 100% probability of a hike at this March meeting, as data since the last FOMC meeting has been constructive.  Politics and trade will also be important topics this week as a trade war could break the positive feedback loop between growth and markets.  As discussed last week, the most important risk regarding trade (and consequently, global growth) would be sanctions against China for intellectual property violations.  The US ITC is supposed to conclude its Section 301 investigation by August, but judgement could come sooner.

My Top 10 1 Reads of the Week:

  1. Financial Times: This is Nuts, When Does Netflix Crash?

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