Another beginning of a summer month, another bumper payroll report. The July payroll growth in the U.S. economy was significantly better than what the markets were expecting. From an employment and consumption standpoint, this is obviously good news. Low levels of unemployment and decent growth in income growth and consumption have been the biggest, and perhaps the only, set of positives fueling U.S. GDP growth. As you would expect, equity markets are rejoicing and the S&P 500 Index is making new highs. Who would quarrel with that interpretation of the incoming strong data? The strength of the U.S. labor market is now the envy of the developed world.

At the risk of being a wet blanket, that interpretation may be too simplistic and may not jibe with other incoming data. The problem is that the strength of the labor market is not translating into strength of the overall economy. In fact, both the nominal and real GDP growth rates for the economy have been very low over the last two quarters. In other words, companies are hiring more people, who in turn are consuming more, but, the aggregate production of goods and services in the country remains subpar.

Productivity Powers Economic Growth

The only way to reconcile these two realities―strong labor markets and low nominal GDP―is to look at things in terms of productivity. The economy is hiring more people but those people are not as productive as they’ve been in the past and are not producing as much in incremental new products and services. As a result, productivity growth―the essence of economic strength―has been and will likely remain subpar. That, in turn, is a big problem for the economy.

To be sure, labor market growth and productivity growth don’t have to materialize concurrently. At various points in time, there has been material lag and productivity growth has bounced back after a few quarters.

But this issue is critical and needs to be resolved rather quickly. Current productivity growth is almost 1.5% below historical average growth rates during prior business cycles, according to a June 7th report from the Bureau of Labor Statistics. That’s a humongous amount. It’s also important to note that business investment growth, the primary driver of such productivity growth, has been pretty much missing in action as the current business cycle has matured. And if we examine the productivity rate across the entire current business cycle, we’ll find that today’s mediocre full-cycle productivity rate was boosted by high productivity growth in 2009-2010, at the beginning of the cycle. In the last year, productivity growth has been plumbing the lows.

Two Equity Market Scenarios

This issue can be resolved in one of two ways:

  1. The optimistic scenario predicts that productivity growth will pick up over the next few quarters. Under that scenario, both real and nominal growth rates pick up and profit margins keep increasing. This would be good news for the equity markets.
  2. The pessimistic scenario predicts that productivity will not pick up. As a result, GDP growth rates will remain relatively subdued and profit margins will shrink. This, in turn, will force companies to cut back on their hiring and effectively take away the only remaining pillar of economic growth―consumption. Clearly, this scenario is far less sanguine for the equity markets.

It’s important to note that there is nothing in the data that indicates productivity growth will not materialize, perhaps with a longer lag than we’ve seen in the past. However, as an investor, we would be remiss if we did not incorporate the other less optimistic, but possible or probable scenario into our risk/reward calculations.

Despite the strength of the labor market, we need to keep watching the productivity and growth data. And despite the recent strength of the equity markets, our market outlook—for a modest upside and a decent amount of volatility—remains unchanged.

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