Uncommon Sense

Record First Half Slump in Productivity Fuels Stagflation Fears

“Don’t confuse activity with productivity. Many people are simply busy being busy.”

Robin Sharma 


Chief Investment Strategist

Lost among all the hair-raising headlines of 2022 is the fact that US productivity suffered its weakest first half performance since the Bureau of Labor Statistics (BLS) began recording data 75 years ago in 1947. Productivity fell 4.1% in the second quarter, on the heels of a 7.4% first quarter plunge.1 Investors must now wait until November 3 when the BLS releases the preliminary productivity data for the third quarter to determine if this alarming slump will continue.

Over the past two quarters, US employment in the nonfarm business sector grew at a very strong 4.3% annual rate while output fell at a 2.3% annual rate, according to the Peterson Institute for International Economics (PIIE). With average hours per worker decreasing, this means that output per hour — productivity — fell at a 6.0% annual rate.

Productivity growth is a major factor in determining how fast living standards rise. If workers produce more per hour of work, then their employers can afford to pay them more without increasing prices, something that causes inflation to rise.

Critics claim that productivity data is too volatile and prone to measurement errors, especially when it’s estimated at high frequencies. Admittedly, the exact magnitude of the productivity decline may be difficult to measure, but the broader trend is clear — output growth is slowing, it may even be negative, while job growth remains strong.

Solid third quarter job gains combined with falling worker output per hour practically ensure the productivity struggles will continue in the short term. Simply stated, an increasing number of workers are producing less per hour. And, in today’s bizarre post-pandemic environment workers are getting paid more for producing that shrinking output. For example, Unit Labor Costs — how much a business pays its workers to produce one unit of output — rose 10.2% in the second quarter, following a 12.7% surge in the first quarter.3 Continued strong increases in employment while output is weak or falling are not sustainable.

US Nonfarm Business Labor Productivity Plummets

Conference Board US Leading Economic Indicators

If Something Cannot Go on Forever, It Will Stop

Businesses should just stop adding unproductive workers. The current situation is fueling fears that businesses will reduce their hiring in the coming year unless there is a large increase in output growth, which doesn’t seem likely with the economy already showing signs of weakening. Logically, any coming US labor market slowdown keeps recession risk elevated.

Wildly, September US nonfarm payrolls (to be released on October 7) are expected to expand by 250,000 jobs. The US has added 5.8 million jobs over the past 12 months and employment has surpassed its pre-pandemic level from February 2020 by 240,000 jobs. There are still two job openings for every unemployed person in the US.4 And small businesses report that they are having trouble finding qualified workers.5 Defying all the expectations that it would falter, the US labor market has been resilient. Labor market strength has provided the Federal Reserve (Fed) the courage to keep aggressively raising interest rates to defeat inflation.

All this suggests that higher wages will remain sticky in today’s tough labor market. As a result, businesses will have to choose between two unpleasant options. They can pass along rising labor costs to their customers by increasing prices or absorb the higher labor costs and decrease their profitability. Neither option is particularly appealing to business owners or their investors.

US Labor Participation Rate Below Long-term Average

US Wealth Growth vs. US GDP Growth: Normalized, Base = 0

So far, businesses have been choosing option one which has contributed significantly to soaring inflation. The PIIE claims that the underlying growth in wages is consistent with personal consumption expenditure inflation, excluding food and energy (core PCE), of 4.5% or possibly higher.6 That figure should be a warning to investors.

At 4.5%, core PCE, the Fed’s preferred measure of inflation, is well above its average inflation target of 2%. Until core PCE gets much closer to the Fed’s inflation target, investors should expect more Fed rate hikes. Perhaps more alarming, the PIIE asserts that additional price increases are more likely than additional wage increases.7 Bottom line: inflation is here to stay.

However, market participants continue to believe that there are limitations to passing along price increases to customers. As a result, investors are now bracing for the negative impacts from option two which would likely slash corporate profitability. So far this year, stock market declines have mirrored the contraction in price-to-earnings multiples. There is growing concern that the potential next leg down for stock prices will be driven by a massive reduction in earnings.

This strange brew of plummeting productivity, rising recession fears, a resilient labor market, stubborn inflation and falling future profitability will likely lead to continued market volatility in the coming quarters — with risks clearly skewed to the downside.

Perhaps Miracles Do Cease

In the 1990s, competitive forces unleashed by the rapid advancements of globalization and technology created a tougher pricing environment for businesses. To boost profits, businesses had to get leaner and meaner by increasing productivity. By 1996, the US was enjoying a productivity miracle of sorts as the rise in output per hour in the nonfarm business sector of the economy jumped to 2.9% per year on average through 2000.8

That may not sound like a big number, but if productivity grows at an annual rate of 2.9%, living standards double in 24 years. That compares favorably to the 1973 to 1995 period when productivity rose by a more modest 1.4% per year on average. At that rate of increase, it takes almost 50 years for living standards to double.9

Alan Greenspan, Fed Chairman at that time, celebrated the productivity miracle and pushed back hard on skeptics that suggested it wouldn’t last long.10 And, why not celebrate? US workers were generating more output per hour worked, inflation was mild, economic growth was solidly expanding, corporate profitability was climbing and stock markets were buoyant. This enabled Greenspan and the Fed to keep monetary policy rates lower than normal which in turn goosed financial asset prices for stocks, bonds and real estate.

Productivity Paradox

Today, de-globalization, post-pandemic aftershocks and rising military tensions between the world’s nuclear armed superpowers have materially changed the economic and investing landscape.

In addition, the ongoing structural shift from quantitative easing to quantitative tightening has created some strange outcomes. US workers’ output per hour is plummeting, yet businesses keep hiring more unproductive workers at higher wages. Inflation is soaring and economic growth is contracting. Corporate profit margins are under attack. And the Fed and many other global central banks have no choice but to aggressively raise interest rates to stabilize prices. In the early 1980s, it took three years and two recessions to finally defeat inflation. It’s a painful process.

These structural transitions are likely to result in continued market volatility and, possibly, lower overall returns for financial assets in the short term. But they also will also likely create new and interesting opportunities for the astute investor.

In the meantime, investors should consider rebalancing portfolios back to their long-term strategic benchmark weights. In addition, consider investing in higher quality, shorter-duration stocks and bonds whose income may offset the harmful impacts of inflation and rising rates.


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