As economists debate whether the recent slowdown in productivity growth in the United States and elsewhere is being measured correctly, investors and advisors should give their attention to strategies that can help them “get the most out of slower growth,” says Charles Schwab Chief Investment Strategist Jeffrey Kleintop in his latest market outlook.
“The focus for investors shouldn’t be on the exact number, but instead on the general trend that productivity is lower now than in the past …,” he stated.
If productivity growth stays low in the years ahead, which many economists expect it will, investors and advisors stand to benefit from making portfolio and other adjustments in light of these five longer-term and associated effects, according the Schwab strategist:
1. Inflation Returns
According to Kleintop, the slowdown in output per hour in recent years has overlapped with recessions in Europe and Japan and weighed on global demand. “This weakness in both supply and demand has allowed inflation to remain low,” he explained.
But slower growth in output per hour over the long term tends to lead to higher inflation over time, since output grows more slowly relative to demand. Some countries with below-average productivity growth over the past 25 years, like Brazil, Russia and South Africa, have also seen much higher than average rates of inflation, Kleintop points out.
“Investors who want to guard against inflation should gravitate toward industries that benefit directly from it, such as energy and materials as well as companies that produce consumer staples,” he said. “These companies stand a better chance of passing along higher costs to consumers.”
2. Tax Revenue Shortage
With slower economic growth comes weakness in tax revenue, which may not expand fast enough to keep up with pension and healthcare needs. This can strain budgets and deepen worries over high debt levels – and these trends could push interest rates higher, according to Kleintop.
“Investors may want to limit their exposure to stocks in industries dependent upon government spending like defense and in the interest rate-sensitive utilities and telecommunications services sectors that have outperformed the global markets so far this year, [as] measured by the MSCI World Index,” the strategist wrote.
3. Emerging Market Growth
Economic growth, as represented by GDP growth, is often calculated by adding the growth in the labor force and the growth in labor productivity.
While developed market economies being forced to contend with the double challenge of slow to negative labor force growth and slower productivity growth, emerging market economies have much faster labor force growth, on average, and have not seen a slowdown in productivity growth in recent years, according to Kleintop.
Though there could be “a lagged slowdown yet to be felt in their productivity growth as emerging markets adopt past developed market innovations, there appears to still be more to come,” he explained. For instance, better roads and rails in India could continue to lift productivity for the near future there.
“Investors may be able to find better and increasingly more efficient growth among the emerging markets,” he said.
4. Profit Pressure
In the long term, lower productivity growth may lead to faster growth in labor costs, says Kleintop, and that can pinch profit margins.
“Investors may want to favor those sectors that can more easily substitute technology for labor or are less exposed to labor costs as a percent of total costs,” he said.
“Retailers in the consumer discretionary sector and makers of machinery in the industrials sector have demonstrated an ability to manage labor costs through technology,” according to the Schwab strategist.
5. Less Creative Destruction
Some of the top 10 companies that make up the MSCI All Country World Index of global stocks — Amazon, Facebook and Alphabet — have been around less than 20 years, says Kleintop, and the “creative destruction” they embody has displaced slower growers from the top spots.
In the future, to the extent that slower productivity growth is due to slower pace of innovation or adoption of new technologies, this trend “could benefit the currently dominant, mega-cap companies as they face fewer upstart challengers,” he explains.
In addition, the slowdown in productivity growth has also seen a drop-off in new business startups, Kleintop poins out.
“For investors this may mean favoring the mega-cap stocks over smaller competitors, since current leaders may not be displaced as quickly or have their market position challenged as aggressively, which may push their valuations higher as they sustain better relative profit growth,” he said.
Investors and advisors who can make the most out of a slower growth environment “may help define investment success in the coming years,” Kleintop adds.
Of course, he advises, it will be important to monitor and adapt to the pace of productivity growth “as conditions evolve.”
Furthermore, these potential long-term trends may help advisors and investors “find bright spots among mega-caps and emerging market stocks,” the strategist concludes.
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