Productivity Growth Improvement
Productivity Growth - Another stat which has been in the doldrums in this expansion is productivity growth. Low productivity growth has been called an impediment to real wage growth. It has been so low this recovery, some complain productivity isn’t been measured correctly.
By ‘eyeballing’ the economy, some skeptics claim it’s unlikely that productivity has been weak when the mobile internet has proliferated in the 2010s.
Q2 productivity growth improved. Quarter over quarter seasonally adjusted annualized productivity growth was 2.9% which beat the consensus for 2.5% growth. The previous quarter was revised down from 0.4% to 0.3%.
As you can see from the chart below, the 5 year annualized productivity growth hit 1% for the first time since 2014. In the chart below labor growth is a plug which means it’s the difference between GDP growth and productivity growth.
As you can see, 5 year annualized GDP growth in 2018 is on pace to accelerate after being stagnant since 2014.
Productivity growth accelerated because output growth increased while hours worked slowed. Because compensation growth slowed, unit labor costs were down 0.9% on a seasonally adjusted annualized run rate.
This missed the consensus for -0.2%; the lowest estimate which was -0.6%. Q1 unit labor cost was revised from increasing 2.9% to 3.4%. As you can see, both productivity and unit labor costs reversed Q1 results.
This unit labor metric was interesting because typically those who follow the business cycle claim inflation at the end of the cycle occurs because the labor market gets too full.
Productivity Growth - The Weak Expansion Turning Around?
There have been a few stats this cycle which haven’t been up to snuff. One example is the wages millennials have earned compared to previous generations. Millennials have been saddled with student debt only to get the same salaries or lower ones, in real terms, as compared to older generations.
Whenever stats which have showed the weakness of this recovery have been brought up in the past few years, it seemed like the consensus was that this is the ‘new normal’.
It took until Q2 2016 for the homeownership rate to bottom at what was the lowest rate in decades. There is recency bias in economic analysis.
This bias makes analysts assume the new trends will continue. You can explain why the new trends exist, but not everything stays the same. In the past 18 months, this has begun to look like a real expansion as growth has accelerated.
Maybe the expansion up until 2016 wasn’t as good as it gets. If the expansion is getting into form now, there could be plenty of room to go. The output gap is only an estimate.
Productivity Growth - Record S&P 500 Profit Margins
After the labor market gets full, the Fed raises rates to lower inflation which ends the expansion. There was accelerated inflation earlier in the year, but it looks like it is moderating.
The fact that unit labor costs fell in Q2 does nothing to support the notion that the economy is about to see outsized inflation. If workers aren’t seeing their incomes grow quickly and commodity prices are low, then there isn’t a reason for the Fed to get contractionary.
This is also great for S&P 500 profit margins which are also being helped by the tax cut this year. There appears to be a secular increase in profit margins as you can see from the chart below. This has occurred because software companies don’t need to spend as much money on workers.
Their variable cost is almost zero after they spend the initial cost of creating the service or product.
Productivity Growth and Slowing Nominal Wage Growth
On a year over year basis, you can see unit labor costs are still growing faster than productivity growth, but unit labor cost growth has slowed in the past 3 quarters.
Productivity growth tightened the gap this quarter as it accelerated. Output was up 4.8% after increasing 2.6% in Q1. Hours worked increased 1.9% which was below Q1’s growth rate of 2.6%.
Nominal compensation growth was only up 2% which fell from 3.7% in Q1. This isn’t consistent with the strong job growth in the first half of the year. It is consistent with my thesis that the labor market isn’t full yet. I think it will be full in 1-2 years.
Adjusting for inflation, real compensation growth was 0.3% in Q2 which increased from 0.2% in Q1.
The latest numbers from June and July show real wage growth is negative.
Real wage growth usually falls at the end of the cycle because inflation increases. I think year over year inflation will increase in the summer, but then decline in the fall as tougher comparisons will be lapped.
Productivity Growth and Monopolized Economy
Average real wage growth this cycle has been strong compared to the previous 3 cycles. The past 2 months of negative real wage growth haven’t had much an effect on the overall data since this expansion is 9 years old.
The chart below shows one of the limiting factors for wage growth is the concentration of industries. The blue line shows wage growth and the yellow bars show the 3 year average of the number of industries with rising concentration. The concentration bars are inverted because the two factors have an inverted relationship.
It makes sense that concentration is somewhat cyclical because weaker small businesses fail during recessions, while the big businesses survive because they have greater access to capital and have seasoned managers who have been through many cycles.
Productivity Growth - Conclusion
This cycle the prevailing theme has been wages haven’t grown as much as they could have because productivity growth has been low. In Q2 productivity improved, while unit labor cost decelerated.
Output accelerated, while hours worked decelerated. I don’t expect that to be a long term trend as Q2 was a very strong quarter. Q3 is shaping up well, but most of the data hasn’t been reported yet.
The increased concentration in industries could be blamed for some of the recent weakness in wage growth.
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