The Next Hard Questions: Investment & Productivity

Investors need to look past the latest promising data to understand how firms will sustain their earnings.

Woo hoo! Solid first quarter U.S. growth; earnings season off to a hopeful start; markets testing new highs. But investors wondering how long it will last need to look beyond the Fed’s next move or the fine print on any China trade deal.

The next hard questions are for CFOs and CTOs. 

Investment committees need to find useful ways to put recent tax windfalls to work to grow earnings and extend the cycle. More important will be whether creative technology teams can help shape new business models that drive higher levels of productivity.

Much of the benefit from the 2017 tax cuts went straight to shareholders through buybacks and dividends. The latest data offers some sign of hope, but it’s hardly clear it will be sustained.

U.S. CAPITAL GOODS ORDERS Y/Y GROWTH RATE

Source: Factset, as of March 29, 2019

U.S. PRIVATE DOMESTIC FIXED INVESTMENT Y/Y GROWTH RATE​​​​​​​

Source: Factset, as of December 31, 2018

True, large-scale investments take time to design and implement, so the trends may still pick up. For now, however, companies seem to be hesitant to commit large sums amid all the talk about the cycle ending. 

They may also be wary that the tax benefits may not be sustainable given the parlous state of the U.S. budget deficit. More likely, they are still trying to figure out how best to deploy new capital in the current state of enormous political uncertainty. A China deal may eliminate recent tariffs, but firms should plan on the risk that they may return, rethinking existing supply chains and addressable markets.  Moreover, the uncertainty extends from Asia to Europe, where the president is now talking about automobile tariffs.

But beyond choosing how to reinvest in their current business models, firms also face the larger, more complicated task of understanding if their business models are about to collapse in an onslaught of technological change. Most industries face tech-based startups that target their most profitable business lines at low fixed costs. Many of these newcomers can also take advantage of an existing infrastructure of mobile networks, cloud storage and data algorithms. 

Economists, investors and policy makers bemoan the recent lull in productivity growth, but that should not last - business models that take advantage of the new technology need time to find their footing. 

After a long period of strong performance near 3% in the 1950s and 1960s, productivity growth drifted to about half that through the 1990s. There was a brief and encouraging recovery leading to the turn of the century, which many attribute to the benefits of the Internet and cheaper telecommunications.

But since about 2005, the levels have drifted back down to around 1.5% today, and the question on everyone’s mind is whether they will ever recover.

The United States (like most other developed markets) is already heading for a period of lower growth, given its aging demographics.  Others blame a lack of government investment in infrastructure and education.

U.S. LABOR PRODUCTIVITY Y/Y GROWTH RATE​​​​​​​

Source: Factset, as of December 31, 2018

U.S. UNIT LABOR COSTS Y/Y GROWTH RATE​​​​​​​

Source: Factset, as of December 31, 2018

Then there are worries that we are just not measuring productivity correctly. Crudely, it is economic output divided by labor input, but there is plenty of room for slippage in both of these numbers. While a ton of steel today compares easily to a ton of steel 10 years ago, globalization means that emerging markets can render incumbents less productive simply by forcing down their prices.

For more complex goods, even if a car today sells for the same price as it did a decade ago, quality improvements that make it safer and more efficient are often hard to capture. So, of course, are the effects of inflation across different industries. For services, which represent an increasing share of developed market activity, the measurements are even more complicated.

For some scholars, economic growth is not guaranteed and the potential contributions from innovation have been exaggerated. But there are growing signs that the next revolution may have just been delayed. As flawed as they might be, productivity numbers have ticked up lately. 

Convincing examples are appearing in technology related to the Internet of Things - data analysis that can monitor industrial operations remotely and predict trouble. Digital models of jet engines in flight, for example, allow for the replacement of worn parts before they actually fail. Tags on livestock and in fields help farmers minimize costs by monitoring the health of their herds or the quality of their soil. The examples are accumulating rapidly. (Watch for our upcoming White Paper “Financing the Internet of Things”, which explores these trends in detail.)

These new technologies take time to gain trust, and sleepy incumbents rarely disappear overnight. But investors looking to extend this current cycle will need to focus on firms that are reinvesting in their current business models and thinking hard about how their next business model will drive greater productivity.