Productivity Is Key

Output per worker. When it slows to a crawl, companies must pass along a higher share of their labor cost increases, putting upward pressure on inflation. Earnings growth slows, and P/E ratios tend to contract. Improvement in the standard of living stagnates, and the economy struggles to expand.

While many foreign economies are experiencing these problems, the U.S. is not. Trailing 5-year productivity climbed to 1.9% per year in the third quarter, up from 1.3% in the previous 5-year period. We appear to be escaping the so-called Productivity Paradox, where advancing technology facilitates the rise of the service sector, which by its nature slows the overall productivity growth rate.

Some credit the pandemic, and the resulting high employee turnover, for better matching the skills of the nation’s workforce with the jobs they hold. Other claim that the investment in remote-work technology is paying off.

More likely, it was the rise of cloud computing, which U.S. corporations began to embrace significantly starting around 2018-2019. The chart on the next page clearly shows a faster rate of productivity growth taking hold in late 2018. While the job-market distortions of the pandemic made it tough to know theunderlying trend from 2020-2022, it’s clear from 2023 and the first three quarters of 2024 that good things are still happening.

While the benefit of traditional cloud computing has likely played out at this stage in the game, the rewards of Artificial Intelligence (AI) are just starting to take hold. The confidence that this emerging technology can keep the productivity ball rolling at the current pace is relatively high. Some think that growth could go even higher – like the 1950s and 1960s, when manufacturing dominated the U.S. economy and 3% annual improvement was typical.

Up until now, very few would have believed that an economy based on services could grow output per worker at that kind of rate. But with AI technology offering the potential to double the output of software developers, reduce report-writing time, and streamline the process of selling and research, suddenly that rate of productivity growth doesn’t seem so impossible. Further out in the future, AI may allow widespread deployment of self-driving cars, and/or humanoid robots that could potentially take over mundane, repetitive jobs in situations where human labor is simply unavailable.

Just sustaining the current 1.9% rate would allow wages to keep rising faster than inflation, which in turn would boost tax revenue – making it easier to service the federal debt. On the corporate front, the ability to largely offset wage gains provides an earnings-growth tailwind of sorts. There’s really only one negative: a higher aggregate return on invested capital tends to increase borrowing demand, which in turn puts upward pressure on long-term interest rates. But we’re already experiencing that effect to some degree.

The stock market, with its elevated forward P/E ratio, appears to be assuming that the higher productivity rate of the last five years will be sustained in the future. Less clear is how quickly the latest capital investments in AI technology will pay off, and whether the regulatory framework will facilitate or impede the rollout of new-age services that have potential to push productivity even higher.

Some worry that AI technology will cause unemployment to rise. That may be true in the short run for some professions, such as software development. But longer term, it is likely to have a positive impact on job creation, as critical labor shortages are alleviated and new types of service businesses become possible.

Fourth Quarter Review
The dollar surged, and long-term interest rates rose, as it became increasingly clear the Fed’s easing plans were being dialed back in the fourth quarter. Trump’s re-election, with his plans to expand the use of tariffs (and extend expiring tax cuts) appears to have made the FOMC more concerned about future inflationary pressures. Stock investors largely looked past that, growing more bullish in anticipation of an administration that is pro-deregulation and less likely to impede corporate buyouts. The S&P 500 gained 2.4% for the fourth quarter, finishing up 25.0% for the year. Smaller stocks lagged due to renewed interest rate concerns; the Russell 2000 finished with a relatively flat 0.3% return, ending 2024 with a gain of 11.5%.

The bond market erased most of its third-quarter gains. The Bloomberg Barclays US Aggregate Bond Index lost 3.1% for the quarter, finishing the year with a meager return of 1.3%. Despite the stronger dollar, bond investors remained wary, fearing that servicing the federal debt would only become more difficult in the years ahead.

As for our portfolios, we outperformed on the stock side where we had sector exposure, but trailed where we didn’t. The story was much the same for all of 2024. On the bond side, our focus on shorter maturities and lower-grade debt allowed us to limit losses for the quarter, while significantly outperforming for the full year.

Looking Ahead
Regarding inflation, there’s potential to see more progress than the market expects for 2025. While the money supply (M2) is growing again, its expansionary pace of roughly 5% is moderate compared to the pandemic-era surge of 20-25%. At this point, the main component keeping inflation above 2% is housing, and because of the lag created by lease renewals there may be further reductions in store. New tariffs, of course, could put upward pressure on inflation, but with advance stockpiling and declining commodity prices the impact is likely to be limited in the coming year.

If inflation does remain stable in 2025, the Fed may have more room to cut than their latest dot-plot suggests. Instead of two quarter-point rate cuts, we might see three or four. That would help restore an upward sloping yield curve, but don’t expect any relief with mortgage interest rates. For that to happen, we would need to see a smaller federal deficit, and lenders would have to become less concerned about pre-payment risk.

U.S. stock prices are somewhat elevated, primarily because investors expect a continuing productivity boom, with 2% annual gains in output per worker to be maintained. That could mean we’ll see a sideways stock market in 2025 as earnings play catch-up to valuations. But the corporate world is investing heavily in AI technology, and if it delivers on its promise we could see additional gains.

After boosting value-stock exposure in the fourth quarter, our stock portfolios have only a modest tilt toward growth, and on the bond side we continue to favor funds with short maturities. We’re comfortable enough with our current portfolio positioning that only minor adjustments should be needed in the months ahead. If anything, we may need to boost risk in our non-sector stock portfolios.

Sincerely,

Jack Bowers
President & Chief Investment Officer