As an economy becomes bigger and more complex, cyclical dynamics explaining cause and effect often get confused or perhaps deliberately flipped for political purposes.
The idea that consumption leads production is almost dogma in Wall Street circles and among progressive policymakers or Keynesians. In fact, the reverse is true, at least if you ask a supply side economist.
Feedback loops certainly emerge in complex economies, and consumption and production develop a symbiotic interdependence, but nothing is consumed before it is produced. Moreover, consumers can't increase consumption sustainably without more income from higher pay or more jobs, both derivatives of increased production of capital goods in the economy (e.g., offices, manufacturing plants, machinery, equipment and software).
Labor productivity has tracked the same pattern of weakness observed in gross domestic product growth since 2000 (see the chart below). It, too, is a factor for which cause and effect is frequently confused.
As newer workers gain experience, productivity rises, of course, but if investment in capital goods inputs as measured by non-residential fixed investment is low, so, too, will labor productivity growth be.
Labor Productivity Growth Rate
During each of the four decades ending in 2000, non-residential fixed investment in the U.S. grew at robust rates reflecting healthy optimism among private-sector capital allocators as to the growth prospects of their businesses (see the table below). But since the arrival of the new millennium, compounded annual growth in non-residential fixed investment has been a small fraction of the rate observed in the four decades prior to 2000, and the result has been a collapse in the growth of labor productivity.
Labor Productivity Growth versus Nonresidential Fixed Investment
We have previously written about the crucial role of private-sector capital spending as the driver of employment and, in turn, wages. Labor productivity is a coincident indicator of wage growth.
That relationship has been dubiously called into question in recent years based on flawed analysis, primarily the omission of employee benefits from compensation.
But make no mistake, the feeble productivity gains observed over the past four years translate into minimal upward pressure on labor demand at a time when the labor overhang is enormous. And forget about real wage gains until the massive labor overhang is absorbed, which will likely require three years or more of steady job growth.
Another symptom of the U.S. economy's lack of vitality and dynamism directly linked to the parsimonious approach toward growth spending among corporate capital allocators is money velocity continuing to languish at multi-decade lows. The Federal Reserve's inability to meaningfully move the economic growth needle off of the worst post-recession recovery since World War II demonstrates the non-monetary nature of the problem.
Of course Fed cheerleaders will invoke the favorite old standby retort of politicians, "Imagine what it would look like if we hadn't done it." The disconnect between the problem of economic stagnation and the Fed's solution of increased money supply and zero-bound interest rate policy is well illustrated in two charts.
The rise in money supply has been offset by declines in money velocity or the rate at which money turns over in the economy (see the chart below). GDP growth has failed to keep pace with money growth.
When companies across the economy are reinvesting, contractors are hired, demand from suppliers rises and headcount is increased, supporting greater consumption. Every dollar in circulation changes hands more rapidly, which is another way of saying that the economy grows faster.
U.S. Money Growth Offset by Falling Money Velocity
Pushing more dollars into the economy while lowering borrowing costs is a fool's errand, with likely harmful, unintended consequences tied to risk apathy in markets, if the absence of private spending and economic dynamism has nothing to do with the availability of capital.
FactSet reported that another record was set in the first quarter for non-financial institution aggregate balance sheet cash for the S&P 500, while capital spending dropped almost 5%, and net shareholder distributions -- dividends plus net share repurchases -- continued at a historical pace. Cash-debt ratios are also near historic highs.
That brings us to our second chart, below. Not surprisingly, the currency pushed into markets by the central bank has mostly been left in reserve, evidenced by the almost perfectly inverse trends of the loans/leases-to-monetary-base ratio, versus the 4.6 times increase in the monetary base since the financial crisis.
Historic Money Printing Offset by Rising Reserve Ratios
So, why have corporations been so unwilling to spend on organic growth? It may come as a surprise to many that the U.S. economy's woes began in 2000.
To be sure, things got worse in 2008, but real U.S. GDP growth from 2000 to 2007 was a meager 2.4%, and there was not a single year that broke 4%. Total fixed investment in that period grew at just 1.8% compounded.
There are a number of factors that explain why 2000 has been an inflection point in the growth of the U.S. economy:
- Sovereign-debt levels began a rapid ascent from less than 53% in 2000 to 65% of GDP by 2008 to more than 105% currently, and there is a looming need for painful remedial fiscal action by way of some combination of Draconian tax increases or spending cuts to meet unfunded liabilities. Higher debt-GDP ratios are associated with lower GDP growth.
- A spike in major new burdensome regulatory rules that began in 2001 and accelerated between 2009 to 2016.
- The highest corporate tax rates among advanced economies.
- The onset of baby-boomer retirement years, beginning around 2011, in conjunction with a multi-year trend of fertility rates below population replacement levels, signaling threats to long-term market demand.
- Diminishing returns from the last great industrial revolution: computers, the worldwide web and mobile communications.
As we have asked before, does it make sense for the S&P 500 to be valued at pre-financial crisis levels? The only distinct episodes of the cyclically adjusted price-earnings ratio exceeding current levels were prior to the 1929 crash and the technology bubble.
At the same time, corporate profit margins are still near record levels and the immutable growth engine of earnings -- the economy -- is growing at half the long-term trend animating those prior peak market multiples. A frothy stock market is being buoyed by zero-bound interest rates, and as things begin to normalize or perhaps sooner owing to some Minskyan catalyst, the correction will come.
Dividend yields will have to rise by way of lower stock prices to compensate stock market investors for the higher risk associated with significantly lower earnings growth. Could the secular multiple contraction be mitigated by structurally lower long-term rates?
Persistent doesn't mean structural. We have long been on record that rates will stay lower longer, below 3% on the U.S. 10-year Treasury for years to come.
But with staggering fiscal deficits looming in the next decade, it isn't prudent to assume that rates don't return to more normal levels eventually.