One of the potential rude awakenings that we advised investors to prepare for in our recent Secular Outlook is a surprising surge of productivity growth over the next several years. While not our base case, we see at least a distinct possibility that productivity emerges from its decade-long slump: Output per hour worked in the U.S. – labor productivity – has grown at an average annual rate of only 1.2% over the last decade and an even more dismal 0.7% over the past five years. In the year to the first quarter, a better economy has brought U.S. labor productivity growth back up to the 10-year trend of just over 1%, and some further cyclical acceleration in the year ahead seems likely. However, the risk scenario we have in mind is a much larger and longer-lasting productivity increase over the secular horizon fueled by an accelerating diffusion of new technologies.
Great, you may say – wouldn’t it be wonderful if we could produce more output with the same input, or at least the same output with less input? As an economist I agree, particularly from a long-run perspective. However, as investors, we should be careful what we wish for, for reasons I will explain in a minute.
A technology synergy
Before that, it’s worth explaining why we think trend productivity growth may be in for a meaningful acceleration over the secular horizon. Matt Tracey and I already laid out the full story a year ago in Productivity: A Surprise Upside Risk to the Global Economy? (full disclosure: Matt did all of the work!), so here’s the short version.
Starting with the obvious, a handful of technologies have emerged that are radically changing the way firms do business. These technologies – offspring of the computer revolution – include artificial intelligence (advanced robotics), simulation, the cloud, additive manufacturing (3D printing), augmented reality, big data, micro sensors and the “Internet of things” (web connectivity of everyday objects). These technologies are now being used, in many cases for the first time, in synergy with one another. Together, they enable businesses to experiment more effectively, better measure their activities in real time, and scale their innovations – and those of their peers – faster. Much of this has been documented in the work of Erik Brynjolfsson from MIT, one of our May 2018 Secular Forum speakers, and his co-authors.
Importantly, smarter experimentation plus faster scalability of winning ideas can speed up the diffusion of best practices from productivity leaders to laggards. As Matt and I discuss in the note, a large productivity gap has opened up over the past decade between leading “frontier” firms and all others. This large gap between leaders and laggards represents strong pent-up productivity gains waiting for a catalyst.
In a nutshell, this catalyst is cost, and the costs of new technologies such as advanced robotics are falling rapidly. This suggests that the diffusion of new technologies across the corporate sector will accelerate in the coming years, leading to potentially large productivity advances. To be sure, the timing and the extent are highly uncertain. This is why we consider a significant acceleration of trend productivity growth over our secular three- to five-year horizon as an upside risk rather than the baseline.
Disruption may test asset markets
Higher productivity enabled by better technology is a boon for the economy, as it enables us to produce more with the same input of factors, such as labor and capital, or to produce the same amount of output with less input. However, investors should be aware that just as the last decade of low productivity growth was near-nirvana as virtually all assets appreciated, a period of significantly stronger growth may turn out to be quite disruptive for asset markets. Here’s why:
First, a surge in productivity growth that raises potential output growth could push real interest rates higher, which would hurt bond investors and could also adversely affect risky assets if real rates rise by more than earnings expectations increase in response to higher productivity.
Second, rising productivity due to accelerating diffusion of new technologies will create not only winners but also many losers in the corporate sector – companies that fall behind in the implementation of technology or whose business models become obsolete as new products or processes emerge. Creative destruction is just a nice way of saying “more defaults.” This will require an intense focus by investors on credit selection.
Third, but not least, a surge in productivity growth due to new technologies is likely to produce, at least temporarily, a surge in “technological unemployment” as traditional jobs are replaced by robots and algorithms, while new jobs may require skills that the displaced workers don’t possess. In the long run, technological advances have been net job creators, but as one famous economist once quipped, “in the long run we are all dead.”
In the meantime, those left behind by digitalization will be a political force to reckon with, potentially giving rise to another rude awakening that we spelled out in our Secular Outlook – a much more radical form of populism than the one currently in vogue in the advanced economies. Think, for example, large-scale redistribution through higher wealth and income taxes as well as universal basic income, aggressive protectionism, potential nationalization of large enterprises or entire sectors, attacks on central bank independence and massive debt monetization.
Again, stronger productivity growth led by accelerating diffusion of ever-cheaper new technologies would be a boon for the overall economy in the long run. However, investors should be careful what they wish for. Just as a bad or mediocre economy was near-nirvana for investors over the last decade, a techno-optimist-dream-come-true next decade may turn out to be much more challenging to navigate.
For detailed insights into the longer-term trends shaping the global economy and market environment, please read PIMCO’s latest Secular Outlook, “Rude Awakenings”.