Global Market Commentary

January 09, 2014

The Bullish Case for 2014: Productivity Growth is the Key

We are looking forward to 2014 with optimism, and we believe the key factor supporting the U.S. and global economies in the present phase of the economic cycle will be productivity growth. Our comments below were prompted by a similar analysis recently published by John Hook of Hook Analytics.

Gross domestic product (GDP) is the market value of all goods and services produced in an economy. This is a nominal value — it must be corrected for inflation to give us “real” GDP. It’s the real growth of GDP that we are interested in as investors. While there are always sectoral and company-level growth differences, it is the outlook for real GDP growth that will give us a “rising tide” or a “falling tide”… and gives us a view of the current economic environment.

We believe this view is of critical importance for investors. Many investors waited out some or all of 2013 on the sidelines and failed to benefit from the market’s gains. Although we don’t expect a ride without bumps in 2014 — a correction of 10 percent or more wouldn’t surprise us — we believe that when the year ends, the U.S. market should be higher by about 10 percent. As the year progresses, the awareness that the economy is showing accelerating growth will ease some of the lingering fears that remain from the Great Recession.

Components of Real Growth

Real GDP growth has two components: population growth, and productivity growth. Population growth by itself will raise GDP, simply because there are more people working, producing, and earning — and demanding goods and services.

However, there are two factors that make population growth insufficient as a driver for growth — and as a driver of corporate profits. First, population growth is basically in a state of decline. It has been observed around the world over the past two generations in particular that worldwide population has grown at a slower pace as the total world population has risen.

It is becoming apparent to demographers that economic development leads to a gradually falling population growth rate. In some highly-developed European countries (as well as in Japan), the population growth rate has even turned negative — meaning that in the absence of immigration, their population would actually be shrinking. And second, population growth, even where it is positive, is simply not very robust — not robust enough to sustain the returns for which investors are looking.

Productivity Growth: The Holy Grail

Since population growth is a small component of real GDP growth, the overwhelmingly important factor for investors to consider is productivity growth — that is, growth that comes not just from an Cost of Chicken in Timeincrease in the number of workers and consumers, but that comes from an increase in how much each worker is able to produce.

The graph below shows the cost of a three-pound chicken expressed in terms of hours worked by an average non-supervisory worker in the U.S. —
that is, how long would someone have to work to purchase that chicken?  The steady improvement over the past century came from productivity growth. Productivity growth makes goods and services more abundant and accessible to consumers — and drives corporate profits for the firms that produce them.

Key Factors in Productivity Growth

Productivity growth rates rise and fall in cycles, just as overall economic activity does. We believe that the present phase of the economic cycle favors rising productivity growth, and we will be attentive to the factors that support it — or work against it. We believe that attentiveness is necessary to enable investors to correctly identify the stage of the economic and stock market cycle.

The first major component of productivity growth is technological innovation. Technological innovation has of course been a key growth driver during all of human history — but it became critically important during the initial phases of the industrial revolution. This was particularly due to technologies allowing manufacturers to exploit new energy sources.

Those two factors — the application of technological innovation to the provision of goods and services, and the discovery and refinement of new energy sources — are key elements of the productivity growth acceleration we believe is getting underway in the U.S.

Computers and the New Industrial Revolution: Big Data, Robotics, and AI

The revolution in computer technology is ongoing, and has been since the 1970s, but it is far from exhausted. One recent sub-revolution, the internet, is now about 20 years old, but more recent aspects of the computer revolution — such as big data analytics, robotics, and artificial intelligence — are really just beginning. (This is why the advent of computing has been heralded by some analysts as a “third industrial revolution” after the initial industrial phases of the 19th and 20th centuries.)

Shale Energy

Besides the cutting edges of the revolution in robotics and AI, we also note the tremendous significance of the shale energy boom. We have made many observations in our letters letter about the astounding effects of new technologies for exploiting shale oil and gas reserves. Even just in the past year, we have seen refinements of shale drilling techniques which promise to bring the U.S. closer to energy independence — earlier than the most optimistic estimates from the beginning of the shale revolution.

Energy played a crucial role in the long term productivity growth of the world economy, and the ongoing shale revolution in the U.S. promises to give the U.S. economy a significant edge in the coming years. We anticipate that technological revolution in this sector is far from finished — and that further improvements will result in still further acceleration of reserve and production growth.
Other Sectors
Of course these two sectors are far from the only sectors where ongoing technological revolutions promise accelerating productivity growth. Two additional sectors where we have seen extraordinary technological changes are biotechnology and materials science — and we expect that more productivity-enhancing innovations are in

So Why the Anemic Recovery?

With these extremely bullish technological factors in place, the question remains why the recovery from the Great Recession has seen historically low productivity growth. 

The graph below shows annual productivity increases for the average U.S. non-farm worker. Recessions are shaded in gray. You can see that a recession is usually followed by a steep improvement in productivity. This is “creative destruction” at work — inefficient business are destroyed, and survivors become much more lean, healthy, and vigorous.

However, you will observe that although the familiar pattern did occur after the Great Recession, it is not as vigorous as other recoveries.



In short, technology is not the only factor. Other factors must be favorable in order for technological innovation for occur — and for its benefits to be realized. We discuss these below — as well as our reasons for believing that some of these other factors may be set to improve in 2014.

Social and Legal Factors in Productivity Growth

Technological innovation does not exist in a vacuum. It exists within a social and legal framework. The proper framework — and its proper functioning — are essential if technology is to produce the greatest productivity benefits.

This is the reason we pay attention to global political and regulatory frameworks. Our analysis embraces political-economic factors, as well as technical and fundamental analysis.

From this perspective, we can see some of the reasons why productivity growth has lagged historical levels during this recovery. It has been held back by other factors, even though technological innovations are extremely favorable drivers.

The Rule of Law

We believe, along with Oxford economic historian Niall Ferguson, that one of the significant features of western cultures is their upholding of the rule of law. In essence, the rule of law means security in one’s person and property from theft, whether from other citizens or from corrupt and unscrupulous government. 

Where such rule of law exists, it permits the accumulation of productive capital; where the rule of law does not exist or is impaired or challenged, the accumulation of productive capital is also hindered. This means that whatever technological advances there may be in theory, cannot be realized to their full extent in terms of productivity growth where the rule of law is challenged.

This factor, we believe, is more bullish for the U.S., Europe, and Japan than it is for China, Russia, and many other parts of the developing world. Any movement in U.S. politics materially advancing adherence to the rule of law will prove beneficial for productivity growth.

Regulatory Organization

A progressive political agenda saw the pendulum swing to the left during President Obama’s first term, and led to a greater emphasis on the government’s role as a promoter of economic equality and a redistributor of wealth.  We do not view the Obama administration as challenging the U.S.’s established rule of law, but increasing the government’s involvement and intrusiveness. We do believe that the pendulum may actually swing away from increasing regulation during 2014. Any lessening of the regulatory burden that U.S. businesses must face, would permit greater productivity growth.

A further factor affecting productivity growth is the balance between regulation and deregulation. There are times where less regulation can be good for the economy, and at other times it can be damaging. For example, a major cut in regulatory burden combined with tax incentives for investing in new companies implemented in the 1980s aided in unleashing U.S. productivity growth in the 1980s and 1990s. On the other hand, after undergoing significant deregulation in the late 1990s, the financial sector undoubtedly laid the foundation for the crisis of 2008 and the Great Recession — making it obvious that more and better regulation was required. In our view, what is necessary is moderate and intelligent regulation.


A final factor worth considering is war. In the past, we are sad to say, war has often been a driver of productivity growth. This is probably because many wars — such as the “European civil wars” of WW1 and WW2 — served to clear away negative and oppressive regimes and helped establish the rule of law and beneficial regulatory frameworks. The establishment of the EU, the rise of Japanese economy, and the increase in global trade and cooperation that followed had their direct roots in European and Japanese determination not to repeat the horrors of the world wars.

More recent wars have offered fewer productivity gains. The more recent conflicts, especially those that have occurred during the global “War on Terror,” have not offered much in terms of improved productivity. They have raised a spectre of an energy shortage for the developed world, and in doing so, they helped focus U.S. energy production companies on the opportunity for producing more energy within the U.S., but in general, they have not added to global productivity.

Manufacturing Growth Trends Up

We were pleased to see manufacturing data finishing 2013 strongly — with an especially strong showing by one sub-component, new orders. Rising new orders suggests labor market improvement as well.

Summary:Increased Manufacturing and Productivity Gains Set a Bullish Tone For 2014

We believe that the fundamentals are in place to support accelerating productivity growth in 2014, and that this growth will be the backbone of market performance in the coming year. And as we have observed before, we have already begun to see data points supporting our thesis. We believe the market is a leading indicator of the recovery of “animal spirits,” and that companies burned by the Great Recession are ready — and are already beginning — to ramp up capital expenditure.

Manufacturing(Texas, of course, has been one of the prime beneficiaries of the shale revolution — so it was already “primed for launch.”)

And of course, we have the historical positives which we have been commenting on for months — historically low inflation, an improving labor market, and still — despite the initiation of the expected Fed tapering — accommodative monetary policy. We will be watching out for higher interest rates; in their absence, the U.S. stock market should perform well for the year.




Average Regional Capex Plans by Federal Reserve district — First and Second Half of 2013
Countdown complete
Chinese IPOs a “Minefield”

In October 2012, the discovery of considerable fraud and misconduct in newly public Chinese companies prompted the central government to shut down the mainland’s IPO market. With new a new regulatory framework in place — part of the raft of reforms put out by Party leaders last year — that freeze will soon thaw.

Almost 800 companies have applied to be newly listed on the Shanghai and Shenzhen stock markets. Analysts expect the first slate of offerings primarily to include large state-owned enterprises. We expect these will be very high quality offerings in terms of the risk of corruption.

The government has very strong motivations to avoid the problems it experienced in 2012. Part of the regulatory change is intended to enhance enforcement mechanisms by using more market reliance. Under the previous regulatory regime, the China Securities Regulatory Commission (CSRC) controlled all aspects of the offering process, including pricing and timing. Now, their function will just be to ensure the applications meet regulatory requirements, and the companies and their underwriters will determine pricing and timing. This will allow the central government to concentrate on those underwriters — and penalize them for misconduct.

Nevertheless, analysts are not sanguine about the prospects for listings by honest companies. They point out that after the first tranche of offerings, the sheer number of companies going public causes them to question the thoroughness of the government’s vetting process. In spite of the new regulatory regime, and in spite of the government’s anxiousness to see that it goes smoothly, the fact remains that China’s business culture implies higher risks than in the U.S and other developed markets.

Effect on U.S. Markets

The effect on U.S. markets is likely to be muted. For now, equities traded in Shanghai and Shenzhen are available to non-Chinese citizens only through the vehicle of mutual funds run by government-approved foreign investment houses. A spate of offerings on these exchanges may affect Hong Kong, but will therefore have little direct effect on other markets — except that it may pull capital away from some Chinese stocks listed in the U.S or elsewhere.

Our broad view on China remains the same. We watch it as a barometer of the global economy, but for now, with a few specific exceptions, we are not interested in owning Chinese equities. We will watch the efforts at regulatory reform and towards the rule of law that continue to develop from Xi Jinping’s administration.

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