A CapEx Stalemate

Last week we received word that Labor Productivity, which is a gauge of US output per labor hour, fell at an annualized rate of 0.6% in the first quarter.  The reading was below the consensus expectation of -0.1% and continued a trend of dismal growth over the past 6-7 years.  Productivity growth is one factor, along with the growth in labor hours, that determines the pace of economic growth.  As such, the current trends remain troubling.

Productivity growth was robust prior to the Great Recession.  In fact, from the fourth quarter of 1999 until the beginning of the recession (December, 2007), productivity increased at an annualized rate of 2.6%.  For the most part, companies and their stakeholders were the beneficiaries of the productivity growth as Unit Labor Costs – a gauge of compensation per unit of output – grew at an annual rate of just 1.5% over the same time frame (see chart below).  So, one consequence of the strong growth in productivity was a surge in corporate profit margins to near-record levels by 2007.  And while workers did participate in productivity improvements to a certain extent, wage gains were modest compared to the gains in corporate earnings.  In other words, the lion’s share of the gains in labor productivity went to capital (shareholders) as opposed to labor (workers).  This has been an ongoing trend for several decades, and it is the major reason for the economic inequality we hear so much about today.

*Source: Bureau of Labor Statistics

Since the recession, which ended in June, 2009, productivity growth has been much more modest.  In fact, productivity increased at an annual rate of 1.0% from the second quarter of 2009 through the first quarter of 2017.  Meanwhile, Unit Labor Costs continued to grow at about the same pace as the previous time frame (1.4%-1.5%).  Most economists attribute the deceleration in productivity growth to under-investment by the business sector.  Shobhana Chandra of Bloomberg says, “As wages remained weak in recent years, businesses relied on new hires rather than more investment in efficiency-boosting technology.”  Therefore, the source of the problem has been the ongoing reluctance of businesses (and the government, to some extent) to make investments in labor-saving equipment, technology, education, training, and infrastructure improvements.  However, now that the labor market has tightened and wage increases are set to accelerate, most economists believe that companies will now be forced into making these investments.  But will these investments materialize even if demand visibility doesn’t improve?  Public companies, for their part, have been handsomely rewarded by using higher profits (and more debt) to buy back their stock and raise their dividends.  Are they likely to change their playbook just because wages are rising?

*Source: Bureau of Labor Statistics

Which brings us to the aforementioned wage gains.  As you can see from the chart below, wage growth (orange line) has indeed accelerated a bit as the unemployment rate has fallen from a recession high of 10% to the latest reading of 4.5%.  This makes sense because employers have to pay more if labor is in shorter supply.  However, if we eliminate the effects of rising inflation (gray line, which represents the Consumer Price Index), growth in real wages has actually decelerated over the past year and a half and has been bouncing around at close to zero for the past four months.  We can interpret this trend as follows: middle-class wage earners are taking home a little more money, but the wage increases continue to be eaten up by the rising cost of necessities like housing, health care, and education.

*Source: Bureau of Labor Statistics

The trend in Labor Productivity since the end of the recession is troublesome because economic growth can only come from two places – growth in labor hours and growth in productivity.  If stricter restrictions are put on immigration and people continue to drop out of the labor force (the Labor Participation Rate has decreased to 62.9% from a high of 67.3% in January, 2000), a greater onus will fall on productivity growth.  However, businesses are unlikely to make big investments in productivity-enhancing projects unless and until visibility improves with regard to demand for their products and services.  And consumer spending, which represents over two-thirds of our economy, is unlikely to improve until gains in income are more widely distributed across the population.  The wage and inflation data is telling us a different story – the middle class continues to get squeezed by weak wage growth and higher costs for necessities.

Could this all change as a result of fiscal stimulus?  Sure, we could get a one-time boost to middle-class incomes (resulting from tax cuts) which could lead to growth in demand.  Based on that increase in demand and cuts in the corporate tax rate, businesses could be incentivized to make capital investments in future growth.  However, until we begin to see more widespread middle-class participation in the economy’s growth, the increases in growth are likely to be fleeting.

So, what’s the answer?  Years ago we said that the answer was more jobs.  More of the unemployed middle class needed sufficient incomes to fuel economic demand.  While more jobs have helped, they haven’t been enough.

Businesses have ample resources in the current environment to invest and increase productivity, but they don’t see the demand for products and services that would justify the investment.  This has created somewhat of a “CapEx stalemate.”  (CapEx is short for capital expenditures)

Looking back to seven years of Quantitative Easing, it’s clear that there were benefits.  Among the unforeseen consequences are high levels of cash that don’t move; wealth creation in stock and housing prices that have had limited stimulative effect; and a middle class with limited wage gains.

Listening to Warren Buffet, Charlie Munger, and Bill Gates earlier this week, it seems that this low-rate, slow-growth CapEx standoff could continue for a few more years.