John Lynch Chief Investment Strategist, LPL Financial
Productivity gains play an important role in economic output, and recent gains support an encouraging picture of the U.S. economy. Productivity, first and foremost, is a primary driver of gross domestic product (GDP) growth [Figure 1]. In the second quarter of 2018, nonfarm productivity rose 2.9%, its fastest pace of growth since the first quarter of 2015. Business sector productivity grew 3.6%, its biggest quarterly jump since the fourth quarter of 2009, while manufacturing sector productivity rose 0.9%. Nonfarm productivity grew primarily from an increase in output per hour of work (versus the number of hours worked). Output increased 4.8% quarter over quarter (its fastest pace since 2014), while hours worked grew 1.9% (versus a 2.2% rise in the first quarter).
While recent gains have been encouraging, the longer-term trend in productivity growth has been muted. Nonfarm productivity grew 1.3% year over year in the second quarter, in line with the 1.3% average since June 2009 (the end of the Great Recession), but below the 2.6% average from the beginning of 2000 to June 2009.
However, signs of sustainable productivity growth are emerging, in our view, thanks to solid economic fundamentals and the tailwind of fiscal stimulus. Productivity, a crucial piece of an economic expansion, may continue to improve as U.S. companies ramp up capital expenditures and the labor market continues to tighten.
SIGNS OF PRODUCTIVITY GROWTH
One driver of productivity gains may be a pickup in business investment. The Institute for Supply Management’s New Orders Index, which tends to be a leading indicator for business spending and the economy, has remained above 60 for 16 straight months, the longest such streak since 1973. New orders of nondefense capital goods (excluding aircraft) have also picked up over the past two years [Figure 2].
These capital goods orders, our best proxy for current business investment, have grown in every month since May 2017 by at least 5% year over year, a pace of growth barely breached from 2012 to 2017. New orders have rebounded strongly from depressed levels after global economic growth slowed in 2015, fueled by fiscal stimulus that has boosted corporations’ incomes.
Business spending is an important input for productivity. If workers have better equipment, better resources, and better training, they have the means to boost production. Tax cuts have provided an extra injection of cash for firms that is fueling a surge in business spending as they invest in resources in an effort to gain market share. Changes in tax laws have also allowed businesses to expense capital purchases and bring their overseas profits back to the U.S. (known as repatriation), providing a lift to business spending. Looking forward, we see a continued pickup in business spending as corporations continue to realize the benefits of fiscal stimulus. In turn, stronger business spending naturally lifts employee productivity.
Improvements in the labor market have also helped fuel productivity. The U.S. unemployment rate has dipped as low as 3.8% this year, a 48-year low. Anecdotal evidence also hints toward U.S. companies’ struggle with a shortage of available and qualified employees. Respondents in the Federal Reserve’s (Fed) July Beige Book noted they had difficulty finding qualified labor, and shortages were reported across several skilled professions. As labor becomes increasingly scarce, employers are forced to focus on improving productivity among their existing workers to boost output.